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Shareholders of closely held corporations are often asked to guarantee loans made to their corporations by lending institutions and third parties.

Before a shareholder agrees to serve as guarantor, endorser or indemnitor of a debt obligation, the shareholder should consider the tax consequences of a default by the corporation.

If a shareholder is compelled to make good on a corporate obligation, the payment of principal or interest in discharge of the obligation generally will create a “bad debt deduction.” However, that deduction may be classified either as a “business bad debt deduction” or as a “non-business bad debt deduction.”

It should be noted as an initial matter that an item cannot be deductible both as a bad debt and as a loss. If it could be treated as either, it must be treated as a bad debt. Also, the need to determine whether a debt is considered to be a business or non-business debt arises only for non-corporate taxpayers; debts of a corporation are generally always considered business debts.

It is generally preferable for tax purposes that a shareholder have a business bad debt rather than a non-business bad debt. The reason is that business bad debt is deductible against ordinary income, and can be either totally or partially worthless. By comparison, non-business bad debt is deductible as short-term capital loss, which is made subject to certain deduction limitations. Additionally, non-business bad debt is deductible only if it is totally worthless.

Under Section 166 of the Internal Revenue Code and the Treasury Regulations promulgated thereunder, business bad debt status is only found where there exists a proximate relationship between the bad debt and the taxpayer’s trade or business. This proximate relationship exists only if the taxpayer can establish that the dominant motivation behind the guaranty payment was business related.

Because the tax treatment accorded to business bad debts and non-business bad debts differs so significantly, taxpayers must demonstrate that their dominant motivation in making the payment was business related if they desire to obtain the more favorable tax treatment.

For example, where a taxpayer, who was a pilot, invested in an aviation supply business, his loan to the business was held to be a non-business debt because there was no discernable, proximate relationship between his trade or business (flying) and his loan to the corporation. In such situations, where the loan or guaranty was not connected with a true trade or business but was nevertheless profit-inspired or was otherwise intended to protect an investment already made, the resulting loss is considered to be a non-business bad debt.

Business bad debts most typically arise as a result of either (a) loans to clients, suppliers, employees or distributors that are made for business reasons but that subsequently become worthless, or (b) credit sales to customers — i.e., goods and services for which customers have not paid but which are recorded in a company’s books as accounts receivable or notes receivable.

In cases with borderline facts and circumstances, a taxpayer can often successfully obtain business bad debt classification by arguing that he made the loan or guarantee in order to protect his employment, because the debt would thereby be considered to be closely related to the taxpayer’s trade or business. In other situations, a taxpayer can often successfully obtain business bad debt classification by arguing that the loan or guarantee was related to a brokerage or promoter-type activity, such as brokering a commodity or property purchase between one’s corporation and others.