Q: I am a member of a LLC that borrowed approximately $500,000 that I personally guaranteed. The LLC has performed poorly, is in a liquidation mode, and I will be required to pay the bank pursuant to the guarantee. My question is whether I can claim an ordinary business deduction for this payment to offset some of the cost.
A: I think you will end up with a short-term capital loss. As you seem to know, this is not favorable because capital losses can only be used to offset capital gains or to the extent of $3,000 per year.
This is a significant issue to you so I will provide you with some tax authorities to support my answer. You may need to share them with the person who prepares your tax return. So if I can’t give you the answer you want perhaps I can at least save you some research time.
Section 166(a) of the tax law allows a deduction for any loss incurred on a wholly worthless debt. Section 166(d) provides that any loss incurred by an individual on a debt other than in connection with a trade or business is a short-term capital loss.
You did not loan money to the LLC. But when you pay on the guaranty the LLC becomes indebted to you in the same manner it was to the bank (a right of subrogation). Presumably the LLC will be unable to pay you so you will have a bad debt loss.
Regulations Section 1.166-9(e)(2) says that where the guarantor may have a right of subrogation (recovery) against the issuer of the debt (the LLC), no deduction is allowed until the right of subrogation is worthless.
Because the LLC was unable to pay its debt, and is in the process of liquidating, it appears that you have no reasonable prospect of recovery under a right of subrogation (subrogation against an insolvent is a worthless debt under Putnam, 252 US 82 (1956)).
The result would be the same as if you had loaned the money directly to the LLC. My answer assumes that the guaranty was not in connection with your trade or business.
The response may change if the facts were different. That is, if you made this guaranty as a business transaction. This would require, at a minimum, that you receive reasonable consideration for making the guaranty.
Regulations Section 1.166-9(e)(1) says that reasonable consideration exists where the taxpayer can demonstrate that the guarantee was made in accordance with normal business practice or for a good faith business purpose.
So understand that I am making certain assumptions in responding to your question. Any loss should be similar to what would have occurred had you loaned the money directly to the LLC.
Most LLC members are not in the business of lending money (or making loan guarantees).
LLC members who contribute to the capital of the entity and later experience a complete loss may sometimes claim an ordinary tax loss (not limited to $3,000 per year).
To get this ordinary loss result the member has to abandon his or her interest in the partnership. An abandonment means you take some affirmative act to give up the interest and receive nothing in exchange.
Receiving nothing in exchange is interpreted to include no relief from the responsibility to repay any debt of the LLC. It tends to be an unusual fact pattern but one that many tax advisers fight to qualify for.
Some advisers may then suggest that you contribute the $500,000 to the LLC, allow the LLC to repay the debt, and then claim an abandonment loss for the (now worthless) LLC interest.
I think this would be aggressive because the step of contributing to the entity would not be undertaken but for the obligation to pay on the guaranty. You are then trying to create two separate steps for tax purposes that are really just one.
The tax law tends to collapse “interdependent” steps – that is, one would not have happened but for the other. This would lead to the same result as a direct payment on the guaranty.
As you might now realize, this can be complicated based on what the actual facts are.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.