“Bad Debt” Tax Break Is Not a Sure Thing

If guarantors are looking forward to nabbing a bad debt deduction, they'll have to wait until the obligation is retired.
Robert WillensApril 16, 2008

The Internal Revenue Service is clear: Section 166(a) of the tax code says that “there shall be allowed as a deduction any debt which becomes wholly worthless within the taxable year.” However, in the case of a guarantor of another party’s debt, a special set of rules operates to determine the time such guarantor is entitled to a “bad debt” deduction (once the guarantor honors the obligation to the creditor).

The rules, laid out in Reg. Section 1.166-9(a) state that a payment made in discharge of the obligation of a guarantor constitutes a worthless debt in the taxable year in which payment is made. In a technical advice letter, the IRS cited Black Gold Energy Corporation v. Commissioner, 99 T.C. 482 (1992), which held that a taxpayer that substitutes its own debt for debt it has guaranteed may claim a bad debt deduction only when it pays the substituted debt. In short, for purposes of Reg. Section. 1.166-9(a), a guarantor’s own note does not constitute an “outlay” and, hence, does not constitute a payment. A note cannot — until its payment — precipitate the debtor’s obligation to the guarantor (the worthlessness of which forms the basis for the guarantor’s bad debt deduction).

To illustrate how the law works, the agency worked up an example in its release of IRS LTR 288014026, December 17, 2007 (a Technical Advice Memorandum.) In the advisory, a taxpaying corporation, Theta Inc., owns the stock of another corporation, Lambda Corp. Lambda issues notes to third party lenders, and Theta does not expressly guarantee the notes but instead, provides “credit support” with respect to the notes. In this regard, Theta formed a trust (Theta2) and enters into “Agreement 2 and Agreement 4,” with respect to the notes.

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Under Agreement 2, Theta is required to transfer to Theta2 cash, shares of Theta’s authorized but unissued convertible preferred stock, and a demand note. Agreement 2 also provides for the funding of a redemption of the notes (issued by Lambda) through sales of Theta’s stock held by Theta2, if such an undertaking become necessary.

Meanwhile, under Agreement 4, Theta is obligated to provide the note indenture trustee with sufficient funds to pay the notes upon their scheduled maturity, should such an undertaking become necessary.

Later, Theta distributes to its shareholders its stock in Lambda. Shortly thereafter, Lambda began experiencing “financial difficulties” and is forced to file for bankruptcy on April 4. Then, on April 6, Theta, in connection with its credit support obligations, exchanges Theta notes for almost all of the notes issued by Lambda. So, by April 9, Lambda has purchased the remainder of Lambda’s notes, with cash.

As a result, Theta claims a bad debt deduction with respect to the Lambda notes that Theta acquired in exchange for its notes. However, the IRS sees it differently. The agency ruled that Theta’s deduction was premature and could not be enjoyed until such time as the Theta notes were retired.

While acknowledging the correctness of the Black Gold Energy Corporation decision, Theta argued that in its case, the IRS ruling was wholly inapplicable. Theta asserted that under both Agreements 2 and 4, its obligation ran not to the holders of the notes (issued by Lambda) but, instead, to the vehicle (Theta1) that Lambda had established to serve as the issuer of the notes. Therefore, Lambda claimed that it had no liability to the holders of the notes.

The IRS disagreed. It concluded that despite the lack of “contractual privity” with the holders of the notes, Theta’s credit support, “was in the nature of a direct obligation” to the holders of the notes. The IRS then bolstered its argument by stating that “…we do not read Black Gold Energy Corporation as requiring contractual privity with, or direct obligations to, the debt holders…” (For legal purposes, contractual privity refers to a relationship that is held to be close enough to support a claim on behalf or against the entity with who the relationship exists.)

The case, in the IRS’s estimation, merely stated that a taxpayer who claims a bad debt deduction as a result of paying debt of another party is entitled to that deduction only when it pays that debt. Thus, the IRS’s view of the Black Gold Energy Corporation rationale is quite expansive. In its opinion, the holding of the case applies to all arrangements within the scope of Reg. Section 1.166-9. This includes any bad debt deduction that is “premised on” a taxpayer’s payment of a debt of another party regardless of the nature of the taxpayer’s obligation.

Accordingly, Theta’s characterization of its obligation as (merely) “credit support” or a “keep well” agreement was immaterial. Theta was subject to the guarantor rules regarding the timing of its bad debt deduction because, regardless of the nomenclature it used to describe the nature and extent of its undertaking, Theta had acted — within the meaning of Reg. Section 1.166-9(a) — in a manner essentially equivalent to a guarantor, endorser, or indemnitor.*

Apparently, this will always be the case when a taxpayer, regardless of his technical legal status with respect to the debts of another party, is attempting to secure a bad debt deduction as a result of the payment of another party’s indebtedness. In such a situation, the deduction will only be available at the time the taxpayer actually pays that debt. For this purpose, the mere delivery of the taxpayer’s note — to defray the other party’s note — will not rise to the level of “payment.” Such payment, sufficient to support a bad debt deduction, will only arise when the substituted note is, itself, paid (in cash or other property).

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

The IRS has frequently adopted an expansive view of the parameters of the term, guarantor. For example, under Section 163(j) of the tax code, no deduction shall be allowed for “disqualified interest”. (The amount so disallowed shall not, however, exceed the “excess interest expense.”) Section 163(j) operates in cases in which a corporation has excess interest expense (an excess of net interest expense over 50 percent of adjusted taxable income) and the corporation’s ratio of debt to equity, as of the close of the taxable year, exceeds 1.5 to 1. For this purpose, disqualified interest is any interest paid or accrued by the taxpayer to a related person if no tax is imposed with respect to such interest. It also includes any interest paid or accrued by a taxpayer with respect to any indebtedness to a person who is not a related person in cases where there is a “disqualified guarantee” of such indebtedness.

A disqualified guarantee is any guarantee by a related person which is either an organization exempt from tax or a foreign person. Most notably, for this latter purpose, the notion of guarantee is broadly construed: It encompasses any arrangement under which a person assures, on a conditional or unconditional basis, the payment of another person’s obligation. See Sec. 163(j)(6)(D)(iii). In addition, Section 956 provides rules for determining the amount of a controlled foreign corporation’s earnings invested in “United States property.” In general, a United States shareholder of such a controlled foreign corporation (CFC) must include in gross income her proportionate share of the amount so invested. For this purpose, United States property includes an obligation of a U.S. person — and an obligation of a U.S. person includes any such obligation with respect to which the CFC is a pledgor or guarantor. A CFC attains this status, with the result that it is considered to “hold” the obligation (of the U.S. person), whenever its assets serve, even though indirectly, as security for the performance of the U.S. person’s obligation. See Reg. Section 1.956-2(c). Thus, the position the IRS took in LTR 200814026, regarding the scope of a guarantee, is consistent with the expansive position it has taken in other contexts in which that term is employed.