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Pledging Company Stock as Collateral – A Good Idea? Let’s say your construction business is encountering a temporary economic downturn, and you could sure use some extra working capital. Maybe you have been advised not to borrow money through the business, as this might make your bonding agent unhappy. Perhaps you do not want to use personal cash or sell off your personal investments, but you realize you are still quite creditworthy and have some significant borrowing capability. So, you find a lender who is willing to loan you some money personally, and you would like to, in turn, infuse that money into your business. There’s only one catch. The lender would like you to pledge your shares of stock in the business as collateral. While that sounds awfully threatening, you persuade yourself to take the risk. After all, you know you will pay that loan back as soon as the business climate improves. And pledging the stock seems rather insignificant compared to the alternative: telling your family that they will have to survive on less. Naturally, things can always get worse, and sometimes they indeed do. Things run amok, you find yourself behind on loan payments, and your creditor exercises its rights to sell your stock to receive payment on the loan. You have now lost your business. Well, that’s pretty bad, but things can’t possibly get any worse than that, right? Or can they? In a recent tax court case (J.S. Rendall, TC Memo. 2006-174), the ex-CEO and Board Chairman of a publicly held company was adjudged liable for income tax on the creditor’s sale of some of his shares of stock! Yes, you are reading that right—he didn’t sell the shares; his creditor did. And he got no money out of it, just discharge of the debt—and a tax liability to boot! The taxpayer tried to claim a bad debt deduction for the loan he had made to the corporation. However, the court ruled that he failed to prove that loan became worthless during the same tax year. The court held that, despite filing for bankruptcy, the sale of all corporate assets and leases, and its overall insolvency, the corporation's technology still had potential value to help it emerge from bankruptcy as a viable going concern. The taxpayer tried to justify a worthless stock loss deduction for the shares he continued to own. The stock was traded over the counter after it was delisted from the stock exchange, and the taxpayer claimed his shares were worthless because of the corporation's non-compliance with SEC rules. However, according to the tax court, there was no evidence, other than the arguably self-serving testimony of the taxpayer, that he was prohibited from trading those shares. In actuality, the shares were still trading at a value slightly more than zero; thus, he also failed to convince the court that these shares were totally worthless, and nothing could be deducted. Imagine losing shares of stock in your business, having to report a “phantom” capital gain on moneys that go to pay back a loan, seeing the business collapse, and then not even getting a tax loss for your remaining shares of stock to offset the gain. It’s like getting hit with one cross punch after another. Meanwhile, you may also experience family problems at home due to a tight financial situation and your own stress level. What started off as a personal sacrifice to save your business ends in a series of events that leaves both your personal and professional life under extreme strain.
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