When an individual or company guarantees a loan for a third party, they are essentially agreeing to assume responsibility for the debt if the borrower defaults on their payments. In some cases, the guarantor may be required to make payments to the lender on behalf of the borrower.
But what happens when the guarantor has to make payments on the loan? Can they claim a deduction for the payment as a bad debt on their taxes?
The answer to this question can be complex and depends on a variety of factors. The court case of Baker Hughes, Inc. v. United States, No. 18-20585 (5th Cir. 2019) sheds some light on this issue, particularly in the context of payments made to a related party.
Facts & Procedural History
This case involves a Houston oil company, BJ Services Company (“BJ”).
BJ is owned by Baker Hughes, which is the taxpayer in this case. BJ conducted fracking services in Russia in 2006. It did so using a subsidiary entity formed in Russia. It entered into a three-year service agreement for this work. The other party to the contract could terminate the contract if BJ’s subsidiary defaulted on the contract. BJ executed a guarantee for the work to be performed by its subsidiary. This is often needed for a foreign country to allow an out-of-country entity to do business in the foreign county.
BJ’s subsidiary did not default on the contract. But in 2006 and 2007, the Russian subsidiary incurred unexpected losses. BJ decided to stop working in Russia. It notified the parties of the contract of its intent to fulfill the duties through 2008, but that it would not renew the contract further.
The Russian Ministry of Finance sent BJ notice that its Russian subsidiary did not meet the capitalization requirements in Russia. The notice advised that the Russian tax authorities had the right to liquidate the company if the subsidiary did not increase its assets in Russia. In response to the threat of liquidation, BJ transferred $52 million to its subsidiary. BJ estimated that these transfers saved it from incurring a $160 million loss.
BJ claimed the $52 million as a “bad debt expense” on its U.S. income tax return for 2008. As a large U.S. company, BJ is under continuous audit by the IRS. The IRS auditor disallowed the bad debt expense. Since the issue was not resolved in appeals, tax litigation ensued.
About Tax Losses for Bad Debts
Section 166 provides a mechanism for the deduction of bad debt losses, which can help to offset other income and reduce overall tax liability. However, the requirements for claiming this deduction are strict and must be carefully followed to avoid issues with the IRS.
The first requirement for claiming a bad debt deduction under Section 166 is that the debt must become wholly or partially worthless during the taxable year. This means that the taxpayer must have a reasonable belief that the debt will not be repaid and must be able to demonstrate that the debt has become worthless. This may be when a business fails or some other identifiable event. The IRS frequently audits tax losses years after they are reported and argues that the loss was taken in the wrong year. Given the lengthy time for the IRS to start the audit, it is often impossible for the taxpayer to go back and take the deduction in the prior year as the time for filing an amended return for the prior year has passed.
Furthermore, the debt must be for a fixed or determinable sum of money, meaning that the amount owed must be specific and known. Loans that are contingent on future events or that are subject to variable interest rates may not qualify as bona fide debts for purposes of Section 166. The regulations explicitly state that a gift or contribution to capital is not considered to be a bona fide debt under Section 166. This means that taxpayers cannot claim a bad debt deduction for amounts that were intended to be gifts or contributions to a business or other entity.
In addition to these requirements, as relevant in this case, the regulations also set out specific criteria for determining whether a debt is a bona fide debt. The debt must arise from a debtor-creditor relationship, which means that there must be an enforceable obligation to repay the debt. This obligation must be based on a valid and enforceable agreement, such as a promissory note or another legal instrument. And the borrower should have sufficient credit to repay the loan and the fact that it is a loan should be well documented.
Bad Debts for Loan Guarantees
The regulations also address bad debts for loan guarantees. It provides that taxpayers can deduct payments (of principal and interest) made on loans they guaranteed as part of their business. The regulations say that these payments are deductible as a bad debt.
To be deductible, there must be:
- An agreement entered into in the course of the taxpayer’s trade or business or a transaction for profit.
- An enforceable legal duty upon the taxpayer to make the payment (legal action need not have been brought against the taxpayer).
- The agreement had to be entered into before the obligation became worthless (or partially worthless in the case of an agreement entered into in the course of the taxpayer’s trade or business).
There are several court cases that address loan guarantees. As explained below, these cases allow bad debt deductions by assuming that the guarantor stepped into the original debtor’s shoes. This brings us back to this case.
Payments to a Subsidiary vs. to a Third Party
In this case, the court had to determine whether BJ sustained a bad debt that triggered a tax loss. BJ guaranteed its subsidiary’s services. BJ had $52 million and then it paid the $52 million to its subsidiary. Does that trigger a tax loss?
The taxpayer argued that it was entitled to a bad debt deduction for the payment it made as a guarantor of its subsidiary’s services. It reasoned that its U.S. business paid out the money and, thus, it must have a tax loss. There is some authority for this. But this authority involves payments made directly to unrelated third-party creditors.
The IRS argued that a guarantor can only claim a bad debt deduction if the original obligor could have claimed the deduction if it had made payment. In this case, the subsidiary would not have been entitled to a deduction for a payment its parent company made to it. It would only be entitled to deduct a payment it made to a third party. Put another way, according to the IRS, because the payment was not to a third party to the subsidiary owed money, there was no obligation for BJ that could trigger a bad debt deduction.
The trial and appeals courts agreed with the IRS:
The Supreme Court has analyzed the sorts of guarantor payments that are deductible as bad debts. See Putnam v. Comm’r,352 U.S. 82 (1956). There, the taxpayer made a payment to a creditor in discharge of the taxpayer’s obligation as guarantor of corporate notes of a debtor. Id. at 83. The Court reasoned that a performed guarantee to pay a debtor’s loan was a bad-debt deduction because upon paying the guarantee, the guarantor “step[ped] into the creditor’s shoes.” Id. at 85. When the guarantor was then unable to “recover from the debtor” the guaranteed and paid amount, the performed guarantee was functionally “a loss from the worthlessness of a debt.” Id. The taxpayer’s ability to claim the bad-debt deduction as a guarantor was the result of the existence of an underlying debt.
Thus, the appeals court concluded that payments made to subsidiaries do not trigger bad debt losses for tax purposes. If BJ had paid a third party on behalf of its subsidiary pursuant to a guarantee, it could have triggered a bad debt deduction for tax purposes.
This court case provides important guidance on the requirements for claiming a bad debt deduction, particularly in the context of loan guarantees. To claim a bad debt deduction, the debt must be for a fixed or determinable sum of money, and the taxpayer must have a reasonable belief that the debt will not be repaid and be able to demonstrate that the debt has become worthless.
In the context of loan guarantees, payments made directly to unrelated third-party creditors may trigger a bad debt deduction, but payments made to subsidiaries or related parties generally do not qualify. As with any tax deduction, it is important to carefully follow the requirements and seek professional advice from a tax attorney to avoid disputes with the IRS.