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TAX CLINIC

Under Sec. 162, reasonableness may outstanding debt upon default without which would not affect his or her basis
be determined by benchmarking the the lender’s having to make additional in the stock. However, if the shareholder,
amount against amounts paid for similar demands of the debtor. Alternatively, at any point, makes a personal payment
services. Regs. Sec. 1.162-7(b)(3) says, with a guaranty of collection, the lender to the lender, such payment would likely
“It is, in general, just to assume that must exhaust all other legal remedies be a contribution to capital and would
reasonable and true compensation is before requiring payment from the increase the shareholder’s stock basis.
only such amount as would ordinarily guarantor. For a minority shareholder S corporation shareholders do not
be paid for like services by like who is not an officer of the company, obtain additional basis by acting as
enterprises under like circumstances.” risks may be higher by virtue of the lack a guarantor of corporate debt but do
of control. receive additional basis upon making a
The amount of risk payment to the lender (see Regs. Sec.
The first factor also calls for an assess- Customary fees 1.1366-2(a)(2)(ii)). However, different
ment of the financial risks. However, The second factor listed by the court rules apply to partnerships. A partner
risks can vary dramatically, even among considers whether similar businesses providing a personal guaranty may be
otherwise similar companies. “customarily pay such fees.” It does not entitled to an increase in the basis of his
Historically, banks offered loans that speak to the value of the guaranty to or her partnership interest by virtue of
were collateralized by the borrowers’ the business, the risks involved, or the guaranteeing the partnership’s debt (see
assets but were not guaranteed by their fee amount. Instead, it simply refers to Regs. Sec. 1.752-1 regarding a partner’s
shareholders. Back then, banks also practices at other companies. Obtaining treatment of recourse liabilities).
offered lower interest rates if and when evidence of such practices at other
the borrowers’ shareholders personally private companies may be difficult, Methodology
guaranteed the loans. Once both rates especially with those that bundle any Due to these complications of assessing
were known, the risks could then be guaranty fee into salary or bonuses risks and identifying amounts paid by
evaluated from the difference in such with no bifurcation. Private companies similar companies for similar guaranties,
rates. However, it is not that simple do not commonly designate separate there is not a well-established,
now, since lenders have stopped offering amounts for individual services provided one-and-only method of computing
unguaranteed loans, even when the by officers. the fee amount. Each situation must be
company provides hard assets and considered individually with whatever
receivables as collateral. Demand for compensation reliable information is available.
Now, a wider range of factors Note that the third factor above requires Certainly, determining a guaranty fee
may need to be considered. The that the guarantor “demand” a fee in requires careful consideration of both
analysis might focus on the number of exchange for the guaranty. This would the amount of the exposure and the risk
guarantors and their liquidity and net presumably occur before signing the of default.
worth. The analysis could also consider documents. Assessing risk would also The analysis may also include
whether the guaranty was required occur before signing the documents, comparing the cost of the debt to the
by a government agency, such as the since Regs. Sec. 1.162-7(b)(3) says, cost of equity. It may not make sense
U.S. Department of Agriculture (see “The circumstances to be taken into for the cost of debt, including the
Bordelon, T.C. Memo. 2020-26). consideration are those existing at the interest paid to the lender plus the
Any requirement for the shareholder’s date when the contract for services was guaranty fee, to exceed the return that
spouse to also provide a guaranty, or the made, not those existing at the date potential shareholders would expect on
need to allow a lien to be placed on the when the contract is questioned.” This their investments in the company. In
guarantor’s residence, could speak to the requirement may prevent a shareholder’s determining an appropriate fee amount,
risks, as well as affect any comparison to guaranty from being used to justify the the analyst may need to make certain
“like services.” The borrower’s revenue amount of his or her compensation after assumptions. For example, it may be
stability, profitability, debt-to-equity the fact, such as in an audit or court case, necessary to assume that the guaranty
ratio, and liquidity could also be among if it was not documented earlier. agreement is enforceable and that the
the top factors in assessing risks. loan was in fact made to the company
The type of guaranty agreement Contributions to capital and not indirectly to its owner.
could significantly affect the risks. A If no fee is paid, the shareholder will The form or method of fixing
guaranty of payment (the more typical have made an unrecorded contribution compensation is not decisive as to
type) obligates the guarantor to pay the to the capital of his or her company, deductibility (Regs. Sec. 1.162-7(b)(2)).

8 September 2022 The Tax Adviser