Legal News and Articles

Written By Thomas J. Barnes, Esquire

In 1984, the Superior Court of Pennsylvania decided a loan foreclosure case that turned on the enforceability of a loan guarantee.  The guarantee was given by the corporate borrower’s stockholders, who pledged their houses as security.  The lender had the opportunity to collect from a readily available fund of cash collateral belonging to the corporate borrower, which would have extinguished the loan guaranty.  The lender neglected to do so, and decided instead to enforce the guaranty by foreclosing on the guarantors’ homes.  The case is an illustration of the differences between what the law classifies as a guarantor versus a surety and, in particular, the rights and obligations of someone standing behind the loan when the borrower defaults and the lender comes knocking on the door.

Background.  Ten years before the Superior Court decided the case[1], Gerald McCrossan and Paul Brutsche, owners of a pharmacy business, borrowed about $72,000 from First National Consumer Discount Co.  The loan was made to their jointly owned corporation, McCrossan’s Pharmacy, Inc.  It was secured by a promissory note from the corporation, mortgages on each owners’ home, and a “Guaranty” signed by McCrossan and Brutsche.  The bank also filed a UCC financing statement covering inventory, furniture and fixtures in the store.  As a result, the collateral included both the business’ assets and the owners’ homes.

The next year, 1974, the pharmacy obtained another loan from First National for $13,890.00.  This loan was secured by a second mortgage on the McCrossans’ home.  After a few months, the pharmacy defaulted on this second loan.

In an effort to preserve the business, First National suggested that the pharmacy extend its payments and refinance the 1974 loan.  The McCrossans signed another promissory note for the modified loan, both individually and on behalf of the corporation.

In March of 1977, the corporate borrower sold the pharmacy business operation for almost $50,000, an amount far short of the $85,000 it still owed to the bank.  The corporate borrower filed an interpleader action in the Court of Common Pleas of Delaware County, depositing the money with the Court and asking the court to supervise the division of the cash proceeds among its creditors.  The money generated from the sale was placed in the court’s custody for ultimate distribution to secured and unsecured creditors.

For reasons not made clear, the bank never seriously pursued its rights to seize the cash in the fund.  It had an undisputed right to do so.  The lender had a perfected UCC Article 9 security interest in the corporate borrower’s non-real estate assets, which had been converted to cash and deposited with the court in Delaware County.  The court distributed the money to other creditors, paying a little more than $3,000 to the lender.

Whether the lender’s next move was planned or not is unclear.  The bank moved to foreclose on the mortgages on the McCrossans’ and Brutsches’ homes, and they naturally objected.  The trial court in Delaware County halted the foreclosures, concluding that the bank’s failure to collect from the cash collateral fund barred it from trying to foreclose on the mortgages.  The trial court said it was the bank’s fault that the collateral was lost, and so it would be unfair to allow the bank force the McCrossans and the Brutsches to make good on the Guaranty because their right to turn to the cash collateral for reimbursement had been destroyed.

The lower court also concluded that the Guaranty document made the McCrossans and the Brutsches “sureties”.  Under surety law, the bank had an obligation to the sureties to preserve the collateral in the fund for the sureties, so they could collect from it if forced to pay the bank in order to make good on their surety obligation.   Since the bank had lost the collateral, the lower court excused the McCrossans and the Brutsches from liability to the bank.  The bank appealed.

First Issue: Was This a Guaranty or a Suretyship Relationship?  The initial question raised by the lender was, were the McCrossans and the Brutsches guarantors or sureties?  Sureties are primarily liable to the lender; that is, liable instantly when the borrower defaults, even if the bank makes no effort to collect from the borrower/debtor.  Guarantors, on the other hand, are secondarily liable; that is, liable to the bank only if the bank first tries to collect from the borrower/debtor and fails completely or in part.  The distinction mattered in this case because, if the borrowers were sureties, then the bank’s failure to pursue collection from the fund would have damaged the sureties’ right to collect from the fund if the McCrossans and Brutsches were unable to pay the bank.

If the Guaranty document made the McCrossans and the Brutsches guarantors of the loan, instead of sureties, the bank would not have been able to foreclose on the mortgages, but would have first been required to try and recover whatever it could from the business’ asset base.  Those assets were sold for cash and were deposited in the court’s account.  Since the bank never followed up on its claim against that money, the lower court barred the bank from getting the full amount of its claim, and only allowed it to collect about $3,000 from the fund.

The lower court determined instead that the McCrossans and the Brutsches were sureties, meaning the bank had no obligation to try and recover from the corporate borrower first.  Under Pennsylvania law, a written agreement made by one person to answer for the default of another makes that person a surety and not a guarantor, unless the agreement contains in substance the words “this is not intended to be a suretyship.”  No such language was in the “Guaranty” involved in the case.

Because McCrossans and the Brutsches were sureties, the bank had an obligation to preserve the cash collateral in the fund for them.  That is, if the bank demanded payment from the McCrossans and the Brutsches as sureties and collected from them, the McCrossans and the Brutsches then would acquire a right of subrogation against the borrower corporation.

Under surety law, the bank had a duty not to impair any security in its control which may have provided the means of satisfying the debt.  “The creditor in such a situation must not prejudice the right of the surety to resort to the security when the surety pays the debt and becomes entitled to subrogation. Impairment of the collateral discharges the surety to the extent that the unimpaired security would have paid the principal debt or to the extent of the surety’s injury.  This principle applies even when the surety was not in a position to enforce its subrogation rights when the impairment occurred.”[2]  Here, the bank had a perfected security interest in the property of McCrossan’s Pharmacy, Inc.: the cash paid into the escrow account.

Second Issue: Did the McCrossans and Brutsches Waive the Defense of Impairment of Collateral?  The second question before the court was, given there was a surety relationship with the bank, did the borrowers waive their right to have the bank preserve the collateral?  The court noted that the “Restatement of Security, § 132 (1941) summarizes the defense of impairment of collateral as follows:

Where the creditor has security from the principal and knows of the surety’s obligation, the surety’s obligation is reduced pro tanto if the creditor

(a) surrenders or releases the security, or

(b) wilfully or negligently harms it, or

(c) fails to take reasonable action to preserve its value at a time when the surety does not have an opportunity to take such action.”[3]

The language of the “Guaranty” provided that the bank reserved its right to exercise any remedy “with respect to any security held by [the bank], and to release, substitute or surrender and to enforce, collect or liquidate, or to fail to refuse to enforce, collect or liquidate, any security of any kind held by [the bank] at any time.”

The court said it was “persuaded that the waiver provision of the “Guaranty” is an unconditional one whereby the sureties (McCrossans and Brutsches) agreed to pay on default of the principal debtor/pharmacy without limitation.”[4]  So the defense of impairment of collateral took a back seat to the “proposition that an explicit waiver precludes a guarantor [or a surety] from asserting them in an action to recover under the guaranty”.

In support of its conclusion, the court said, “under certain circumstances if the creditor has not exercised reasonable (due) diligence in preserving the security, then the obligation of the appellees would be reduced to the extent that they were injured.  However, because the guaranty agreement in the instant case is an absolute and unconditional one, and because the contract of guaranty did not require the creditor to take such action, the foregoing rule of law has no applicability.”  This principle continues to be the law in Pennsylvania.[5]

In commercial financing transactions, the courts give no artificial protections to the borrower, as they often do in consumer loan cases.  Instead, they elect to respect the clear language of the parties’ agreement, made in the context of a transaction between alert and attentive parties with a motive to carefully scrutinize the language of their agreements.

Written by Thomas J. Barnes, Esquire

We have client owners who have approached us who want to provide equity to key employees or minority owners as a performance incentive.  One way to accomplish this is by granting a carried interest to the recipient (also called a “profits interest”); essentially a right to participate in any gain on the sale of the company if and when it is sold.

Like options, carried interests offer the two-fold advantage of deferring taxation for several years and then only at the capital gains rate.   Now that the legislative climate in Washington is such that capital gains treatment for carried interests may be in jeopardy, consideration might be given to the use of capital interests: an outright grant of equity to the employee or minority owner.

A capital interest is an equity interest in a partnership.  LPs, LLCs, LLPs are all treated as partnerships for federal income tax purposes.  The IRS regards it as an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the equity interest.  See Rev. Proc. 93-27.  A carried interest, on the other hand, is any interest that is not a capital interest.

Assuming it is not subject to a substantial risk of forfeiture, the value of a capital interest is considered to be income to the recipient in the year in which it is received.  The income is taxable at ordinary rates, and is not eligible for capital gains treatment at that time.  The dollar amount of income realized is equal to the fair market value of the interest on the date of grant.  The partnership can recognize a deduction for the value of the granted interest (again, assuming it is not subject to a substantial risk of forfeiture).  The recipient of the capital interest must make a timely election to claim the interest is not subject to a substantial risk of forfeiture and is therefore vested for tax purposes.

The grant of a capital interest to someone who does not or cannot contribute assets in an amount equal to the current fair market value of the interest will have a negative impact on the other partners’ capital accounts.  The other partners’ accounts will have to be debited in an amount sufficient to reflect the adjusted percentages of ownership.  For example, two existing partners with capital account balances of $100 each will see $5 of their balances transferred to the recipient of a 10% capital interest who does not contribute cash or assets valued at $10.

Unlike a capital interest, the receipt of a carried interest by itself does not result in the recognition of income on the date of grant.  However, if the recipient of a carried interest who was an employee of the partnership becomes a partner, there will be tax consequences for the new partner.  The new partner will receive a Schedule K-1 reflecting the partner’s allocable portion of the partnership’s income and deduction items and any guaranteed payments for capital or services rendered.  Carried interests can participate in distributions of current earnings, but such participation is usually limited to vested interests.

The reasons for granting capital interests instead of carried interests may include a desire to have minority partners participate in profits (and losses).  The founding or majority partners must not be adverse to dilution and should have received a return of invested capital in the form of distributed profits long before a sale.  We have found that capital interests may be better suited for a service business rather than a capital intensive one where the founder or sponsor contributes a large amount of cash or the asset in a single-asset or capital-intensive business.

Capital interests and carried interests both currently enjoy capital gains tax treatment.   So LLC, LP and LLP owners who favor making key personnel owners and who do not mind the dilution of their own equity interest may find capital interests worthwhile.

The wisdom of granting capital interests as a reward for employee or minority owner performance, which should be discussed in depth with the attorney and accountant, will depend on many factors and is inherently fact-sensitive.  These include the value of the interest on the date of its grant, the recipient’s ability to pay tax on the value of an illiquid asset and the distributive share of profits, a relatively low basis and future gain on disposition which will be taxed at the lower capital gain rate if sold after one year.  Since the result will be a low cost basis, the amount of realized gain will be similar to that resulting from the liquidation of a carried interest.

CIRCULAR 230 NOTICE.  Any advice expressed above as to tax matters was neither written nor intended by Egbert & Barnes, P.C. to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.  If this document is delivered to any person or party other than to our client to whom the advice is directed, the recipient may not and should not rely upon any advice expressed above for any purpose and should seek advice based on the recipient’s particular circumstances from an independent tax advisor.

For more information contact:

Thomas J. Barnes, Esquire

Egbert and Barnes, P.C.

215-886-6600

tbarnes@egbertbarnes.com

Written by Thomas J. Barnes, Esquire

1. Introduction. Among the most common form of loan workout transactions are the voluntary transfers of the asset securing the loan to the lender, or to a buyer approved by the lender. In real estate, the usual method is a deed in lieu of foreclosure. With non-real estate assets like securities or equipment, borrowers also re-title the asset to the lender or the purchaser of the debt obligation. In all these transactions, there are tax consequences to both the lender and the borrower. Here we briefly examine the tax consequences to the borrower.

2. Generally. When a lender forgives all or part of a debt obligation, the borrower is required to report the amount forgiven as gross income .Where the debt is secured by collateral, a borrower who transfers title to the collateral to the lender or a third party, in exchange for cancellation of the debt obligation, might be able to avoid recognition of some the cancelled debt as ordinary income. This depends on whether the borrower is personally liable on debt secured by collateral (“recourse” debt). Recourse debt means the lender has the option of both taking back the collateral and also suing the borrower on the note to recover any excess of the amount owed over the proceeds of the sale of the collateral. Nonrecourse debt is just the opposite: the lender’s remedy for non-payment is limited to taking back the collateral, and so the lender has no recourse against the borrower.

3. Recourse Debt. A borrower of recourse debt secured by collateral is relieved of liability on the debt when the collateral is sold to a buyer who agrees to pay off the debt at the closing . Federal tax law views this relief from liability to be just like a cash payment from the buyer to the seller for use in paying off the lender . Therefore, the cancelled debt amount is included in the amount realized from the sale and recognized as income for tax purposes. The result is the same if the asset is transferred to the lender.

For income tax purposes, the cancellation of a recourse debt obligation is broken into two separate transactions. The first is the sale of the collateral at its fair market value, which will result in a gain or a loss. The second is the lender’s cancellation of the debt itself, after the sale of the collateral. If the fair market value of the collateral is less than the amount owed, then the borrower will recognize the difference between the amount owed and the fair market value as cancellation of debt income. This income is reported as gross income and is taxable at ordinary rates, not as capital gains.

Example 1: A borrower purchases an apartment building for $5,000,000. The borrower pays the seller $1,000,000 in cash and signs a note payable to the lender for $4,000,000. The borrower agrees to be personally responsible to repay the loan, and in so doing agrees that the lender has full recourse in the event of the borrower’s default. The land is mortgaged to the lender. During the next two years, the borrower claims depreciation on the building of $50,000. The borrower pays interest on the loan, but does not reduce the outstanding principal balance. At the beginning of the third year, the borrower sells the property to a third party for $3,500,000. The buyer pays the borrower no cash and, by agreement with the lender, pays the lender, satisfies the debt obligation and then takes the property free of the mortgage. The first transaction for tax purposes is the sale of the property at fair market value. The borrower was “paid” $3,500,000, which, compared to the property’s adjusted basis of $4,950,000 (the original cost of $5,000,000 – $50,000 in depreciation), results in a loss of $1,450,000. The second transaction is the lender’s cancellation of $500,000 of the debt. As a result, the borrower is said to have realized gross income in that amount.

4. Nonrecourse debt. If collateral securing nonrecourse debt is sold to a third party who agrees to pay the loan or assume it, or if it is transferred to the lender in satisfaction of the debt, the transaction is treated as if the borrower sold the property for the amount of the unpaid debt. No cancellation of debt income would be realized. However, the borrower may realize taxable gain or a loss on the transfer.

Example 2: Assume the same facts as in Example 1, except the loan is nonrecourse. The amount realized by the borrower is the full amount of the cancelled debt, $4,000,000. The borrower realizes a loss of $950,000 on the sale ($4,000,000 – $4,950,000).

Example 3: Owner inherits an apartment building and the lot it occupies. On the date of the decedent’s death, there is a mortgage securing nonrecourse debt with a face amount of $255,000. No principal has been repaid, and interest of $7,042.50 is in arrears. The fair market value of the property at the time is $262,042.50, which is the sum of the principal and interest outstanding. For the next several years, the owner continues to operate the property, collecting rents, paying taxes and expenses, and claiming depreciation of $28,045.10 on the building. With the lender threatening foreclosure, the owner sells the property to a third party for $2,500 in cash, subject to the mortgage. The tax treatment of the transaction is as follows :

When nonrecourse debt is cancelled, the fair market value of the collateral at the time of sale or disposition is not relevant for purposes of determining the amount of liabilities from which the taxpayer is discharged or treated as discharged. The full amount of the loan obligation is treated as money received from the sale or other disposition of the property. This is so even when the collateral is encumbered by a nonrecourse loan obligation of an amount in excess of the property’s fair market value .

Example 4: Stockholder borrowed $245,000 to buy stock in a business. The loan was secured by the stock, and was nonrecourse. During the period of time he held the stock, the stockholder claimed deductions for interest paid and for the business’ net operating losses totaling $205,508, and used these deductions to reduce his adjusted basis in the stock. The business later went bankrupt, and the lender foreclosed on the stockholder’s loan. The stockholder realizes a substantial gain on the disposition of the worthless stock, even though he paid no cash for it and was paid nothing in cash when the stock was taken by the lender . The deductions are “recaptured” as gain:

5. Foreclosures and deeds in lieu of foreclosure. When a property has declined in value below the amount of the debt, and the lender forces a deed in lieu of foreclosure or a forced transfer to a third party, the borrower will not only lose all or part of its equity, but will also suffer the recapture of any deductions taken in previous years. Usually the result is the realization of a capital gain.

Example 5. A partnership borrows about $1,852,000 on a nonrecourse basis to finance the construction of an apartment complex, and contributes cash of its own of $44,000. The property’s value declines to $1,400,000 after two years. To avoid foreclosure, the partnership transfers the property to a third person who agrees to assume the mortgage. The partnership’s adjusted basis for the property at the time of the transfer was $1,456,000, the sum of the $1,852,000 borrowing and $44,000 of the partnership’s own money invested in the project, reduced by $440,000 of depreciation.

The partnership loses its invested cash of $44,000 and, even though the property’s value has declined nearly $500,000, the partners will share in a capital gain of $396,000. This represents the recapture of the non-cash depreciation deductions the partnership claimed after the purchase .It makes no difference whether the property is transferred to the lender or to a third party. If the debt obligation is extinguished (that is, not assumed by the third party), it is included in the amount realized.

In a foreclosure proceeding and sheriff’s sale, recourse and nonrecourse debt is treated differently. The amount realized on the foreclosure of a nonrecourse mortgage is no less than the unpaid principal and interest (and other costs). If the sheriff’s sale brings a larger amount, that amount becomes the amount realized. With a recourse mortgage, however, the amount realized sheriff’s sale is the net foreclosure proceeds, whether they turn out to be more or less than the unpaid loan balance. If a recourse lender forecloses but does not take steps to get a deficiency judgment within a certain time period, the foreclosure procedures in Pennsylvania and New Jersey will end the lender’s right to get one. In that case, any excess of the mortgage balance over the foreclosure proceeds is usually cancellation of indebtedness income to the borrower.

Example 6. After foreclosure, the lender obtains $500,000 for the mortgaged property at a sheriff’s sale. The property was subject to an $800,000 recourse mortgage. The lender does not move to obtain a deficiency judgment and so is barred by state law from doing so. The borrower has an amount realized in the foreclosure of $500,000 and will receive a form 1099 from the lender announcing cancellation of indebtedness income of $300,000.

If a recourse lender purchases the property in a foreclosure sale for more than fair market value, the amount realized is the property’s fair market value, not the higher price in the foreclosure sale.

Example 7. Lender obtains $571,000 at sheriff’s sale after foreclosure. The property is worth $375,000 but is subject to a recourse mortgage of $586,000. The winning bid of $571,000 is irrelevant to the calculation of the amount realized and cancellation of indebtedness income :

If the lender does obtain a deficiency judgment, the borrower remains liable for the excess of the mortgage balance over the foreclosure proceeds, and this excess is therefore not immediately recognized as income or applied to reduce basis.

6. Conclusion. Whether a borrower or loan guarantor will have to report realized cancellation of indebtedness income depends on whether the debt is recourse or nonrecourse. The consequences of reporting cancellation of debt income as part of gross income, subject to taxation at ordinary rates, will in turn depend on the individual taxpayer’s ability to deduct losses dollar-for-dollar in order to offset the income. Each taxpayer’s circumstances may make recourse or non-recourse debt more attractive.

For more information, contact Thomas J. Barnes at (215) 886-6600 or tbarnes@egbertbarnes.com

(1) See Internal Revenue Code section 61(a)(12).
(2) Treas. Reg. Section Sec. 1.1001-2(a)(4)(ii).
(3) United States v. Hendler, 303 US 564 (1938) (The “gain was as real and substantial as if the money had been paid it and then paid over by it to its creditors.”).
(4) See Crane v. Commissioner, 331 US 1 (1947); Treas. Reg. Section Sec. 1.1001-2(b).
(5) Commissioner v. Tufts, 461 US 300 (1983).
(6) See Millar v. Commissioner, 577 F.2d 212, 215 (3d Cir. 1978), cert. denied, 439 U.S. 1046, 99 S.Ct. 721, 58 L.Ed.2d 704 (1978).
(7) See Commissioner v. Tufts, 461 US 300, 317 (1983).
(8) Treas. Reg. Section Sec. 1.1001-2(a)(2).
(9) See Frazier v. Commissioner, 111 T.C. 243 (1998).