By Stephen D. Kirkland, CPA, CMC, CFF
Originally published in The Tax Adviser, September 2022. Copyright: AICPA.
It is common for business owners to personally guarantee company debts. This is a valuable service since many private companies could not otherwise obtain financing in the current lending market. Indeed, business owners already face considerable risks and may not want to assume more. When they do, they provide value that justifies additional compensation for themselves.
A recent Tax Court opinion laid out the requirements that must be met to support the payer’s deduction for any such fees. In Clary Hood, Inc., T.C. Memo. 2022-15, the issue was whether the owner/CEO of a construction company had been paid unreasonable compensation. Among his many duties, the CEO had guaranteed business loans, credit lines, capital leases, and surety bonds for the benefit of his company. Expert testimony pointed to the CEO’s personal guaranties of these obligations as partial justification for his multimillion-dollar compensation.
The court agreed that it is customary for the owners of construction companies to guarantee debts and bonds and that compensation for these guaranties is appropriate. The court also acknowledged that such fees may qualify as a deductible business expense under Sec. 162(a). However, the court stated that Clary Hood Inc. had not met all five requirements for deductibility of the guaranty fees. The court’s analysis considered:
- Whether the fees were reasonable in amount, given the financial risks;
- Whether businesses of the same type and size as the payer customarily pay such fees to shareholders;
- Whether the shareholder-employee demanded compensation for the guaranty;
- Whether the payer had sufficient profits to pay a dividend but failed to do so; and
- Whether the purported guaranty fees were proportional to stock ownership.
Reasonable in Amount
The first factor above requires that such fees be “reasonable in amount.” Under Sec. 162, reasonableness may be determined by benchmarking the amount against amounts paid for similar services. Regs. Sec. 1.162-7(b)(3) says, “It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”
The Amount of Risk
The first factor also calls for an assessment of the financial risks. However, risks can vary dramatically, even among otherwise similar companies.
Historically, banks offered loans that were collateralized by the borrowers’ assets but were not guaranteed by their shareholders. Back then, banks also offered lower interest rates if and when the borrowers’ shareholders personally guaranteed the loans. Once both rates were known, the risks could then be evaluated from the difference in such rates. However, it is not that simple now, since lenders have stopped offering unguaranteed loans, even when the company provides hard assets and receivables as collateral.
Now, a wider range of factors may need to be considered. The analysis might focus on the number of guarantors and their liquidity and net worth. The analysis could also consider whether the guaranty was required by a government agency, such as the U.S. Department of Agriculture (see Bordelon, T.C. Memo. 2020-26). Any requirement for the shareholder’s spouse to also provide a guaranty, or the need to allow a lien to be placed on the guarantor’s residence, could speak to the risks, as well as affect any comparison to “like services.” The borrower’s revenue stability, profitability, debt-to-equity ratio, and liquidity could also be among the top factors in assessing risks.
The type of guaranty agreement could significantly affect the risks. A guaranty of payment (the more typical type) obligates the guarantor to pay the outstanding debt upon default without the lender’s having to make additional demands of the debtor. Alternatively, with a guaranty of collection, the lender must exhaust all other legal remedies before requiring payment from the guarantor. For a minority shareholder who is not an officer of the company, risks may be higher by virtue of the lack of control.
Customary Fees
The second factor listed by the court considers whether similar businesses “customarily pay such fees.” It does not speak to the value of the guaranty to the business, the risks involved, or the fee amount. Instead, it simply refers to practices at other companies. Obtaining evidence of such practices at other private companies may be difficult, especially with those that bundle any guaranty fee into salary or bonuses with no bifurcation. Private companies do not commonly designate separate amounts for individual services provided by officers.
Demand for Compensation
Note that the third factor above requires that the guarantor “demand” a fee in exchange for the guaranty. This would presumably occur before signing the documents. Assessing risk would also occur before signing the documents, since Regs. Sec. 1.162-7(b)(3) says, “The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.” This requirement may prevent a shareholder’s guaranty from being used to justify the amount of his or her compensation after the fact, such as in an audit or court case, if it was not documented earlier.
Contributions to Capital
If no fee is paid, the shareholder will have made an unrecorded contribution to the capital of his or her company, which would not affect his or her basis in the stock. However, if the shareholder, at any point, makes a personal payment to the lender, such payment would likely be a contribution to capital and would increase the shareholder’s stock basis.
S corporation shareholders do not obtain additional basis by acting as a guarantor of corporate debt but do receive additional basis upon making a payment to the lender (see Regs. Sec. 1.1366-2(a)(2)(ii)). However, different rules apply to partnerships. A partner providing a personal guaranty may be entitled to an increase in the basis of his or her partnership interest by virtue of guaranteeing the partnership’s debt (see Regs. Sec. 1.7521 regarding a partner’s treatment of recourse liabilities).
Methodology
Due to these complications of assessing risks and identifying amounts paid by similar companies for similar guaranties, there is not a well-established, one-and-only method of computing the fee amount. Each situation must be considered individually with whatever reliable information is available. Certainly, determining a guaranty fee requires careful consideration of both the amount of the exposure and the risk of default.
The analysis may also include comparing the cost of the debt to the cost of equity. It may not make sense for the cost of debt, including the interest paid to the lender plus the guaranty fee, to exceed the return that potential shareholders would expect on their investments in the company. In determining an appropriate fee amount, the analyst may need to make certain assumptions. For example, it may be necessary to assume that the guaranty agreement is enforceable and that the loan was in fact made to the company and not indirectly to its owner.
The form or method of fixing compensation is not decisive as to deductibility (Regs. Sec. 1.162-7(b)(2)). Once determined, the guaranty fee may be paid in the form of a separate fee, a higher salary, or a cash bonus. It could also be paid in the form of equity in the company (see Davis, T.C. Memo. 2011-286, aff’d, No. 12-10916 (11th Cir. 5/16/13)). If equity is used as the form of payment, the guarantor may need to find a source of cash to pay income taxes. Alternatively, it may be possible to structure the guaranty as a tax-free contribution of property to the company under Sec. 351 rather than as a service. The distinction between property and service may be swayed by whether the guaranty is provided because the shareholder is protecting his or her investment or because an officer is protecting his or her future compensation.
Dividends
The fourth and fifth factors listed in Clary Hood are intended to weed out fees that are in fact disguised dividends to the shareholders, which would not be deductible. In Clary Hood, the court noted that the business did have profits but had not paid dividends. However, the court considered the totality of the facts, with no specific weight given to any particular fact. If the tests for deductibility are not met, any fee paid separately may receive dividend treatment.
Final Thoughts
Even though a guarantor may never have to make a personal payment toward the company’s debt, the guaranty may cause issues for the guarantor. For example, that contingent liability could hurt the guarantor’s credit rating. Yet, for the owners of private companies, providing personal guaranties may be a necessary part of the process.