Academic journal article Journal of Accountancy

Shareholder Guarantees of Corporate Debt

Academic journal article Journal of Accountancy

Shareholder Guarantees of Corporate Debt

Article excerpt

Many creditors are reluctant to lend money to closely held businesses because of limited liability protection. In many cases a creditor will insist that one or more of the corporation's shareholders personally guarantee the debt. If the company pays a shareholder a fee for providing a guarantee, is the payment deductible?

In 1983, three individuals formed Seminole Thriftway, Inc., to operate a supermarket. The corporation needed additional capital to purchase land and inventory. To persuade a bank to lend the money, the three shareholders personally guaranteed repayment of the debt. In 1985, Seminole hired a general manager who received stock in addition to other compensation. In 1987, the company paid the original shareholders a fee to compensate them for guaranteeing the debt and deducted it on the corporation's tax return. For tax years 1992 to 1994, the IRS denied the deduction by reclassifying the payment as a constructive dividend. The company paid the additional tax and sued for a refund.

Result. For the IRS. The Court of Federal Claims reviewed prior cases and determined that classification of such a payment as either a deductible expense or a constructive dividend is based on five factors.

* The reasonableness of the payment.

* Whether similar corporations pay their shareholders for loan guarantees.

* Whether the shareholders demanded payment for guaranteeing the debt.

* Whether the company pays sufficient dividends; failure to do so implies the payment is a constructive dividend.

* The proportional relationship between the payment and stock ownership.

Because the government sued for summary judgment, the facts were not in dispute. The parties agreed the fees were reasonable and consistent with those paid by other corporations. This focused the decision on the last three factors.

The Seminole shareholders signed guarantees without demanding any compensation. …

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