Does a taxpayer have to pay income tax if he or she defaults on a guarantee?
Once the lender informs the guarantor that the lender intends to collect a debt directly from the guarantor, the guarantor must decide whether he or she is able to make good on such debt. If the guarantor defaults on all or a portion of such guaranteed debt, the guarantor may be responsible for income tax on this default.
Generally speaking, if a taxpayer is relieved of an obligation to repay a debt (sometimes called debt discharge), the taxpayer recognizes income to the extent that it pays less than the face amount of the debt. There are several exceptions to paying tax on debt discharge income available to most taxpayers, such as discharge of debt in bankruptcy or insolvency.
However, guarantors of indebtedness are entitled to a unique exception. They do not have to pay tax on discharged debt to the extent the payment of this debt would have entitled the guarantor to an income tax deduction. When the original debtor defaults, subrogation results in a liability due from the original debtor to the guarantor. When the original debtor does not pay this subrogated liability, the guarantor becomes entitled to a tax deduction.
So, as long as the guarantor would have obtained a deduction, he or she will not recognize income. This exclusion applies regardless of whether the deduction would have been an ordinary deduction or a capital loss.
Finally, when a taxpayer serves as a guarantor for the debt owed by a partnership, LLC or S corporation, care must be taken to avoid income tax on forgiven debt. Remember, when subrogation occurs, the entity becomes a debtor to the guarantor.
However, if the guarantor forgives this subrogated debt, the entity may have income from discharge of indebtedness. Such tax consequences flow through to individual owners, including owner guarantors.
What should someone consider before agreeing to serve as a guarantor?
First, consider the creditworthiness of the original debtor. Is the debtor financially viable, or is the risk of viability an acceptable risk? Second, is there a way to ‘buy down’ the guarantee? Could the debtor incur a little higher interest rate and avoid the necessity for a guarantee?
Finally, especially if it involves guarantees of family member loans, consider whether the guarantor should charge a guarantee fee of 100 to 300 basis points to document the benefit required to obtain a tax deduction.
WALTER M. McGRAIL, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or [email protected].
