Revitalize Your Understanding: Guide to Bad Debt Loss DeductionsTax Planning
The debate rages on about whether we are already in a recession or will soon be in one.
In this environment, bad debt losses become more likely.
For individual taxpayers, the issue of deducting bad debt losses has been a source of controversy with the IRS for ages.
Read this article for a refresher on the issue along with a potential strategy to get better tax results in one commonly encountered scenario. Here goes.
Bad Debt Deduction Basics
To claim a deductible bad debt loss, you as an individual taxpayer must first be prepared to prove that the loss was from a bona fide loan transaction that went sour instead of from some other ill-advised move such as a contribution to the capital of a business entity that turned out to be a loser, or
an informal advance to a friend or relative that you hoped and trusted would be paid back, but that turned out to be an unintended gift.
Assuming you can establish there was a bona fide debt that has now become worthless, the next issue is whether it was a business bad debt or a non-business bad debt. Tax-wise, this is an important distinction.
Business Bad Debt Losses Receive Favorable Tax Treatment
For federal income tax purposes, business bad debts are treated as ordinary losses that you can usually deduct without any limitations. In addition, you can claim partial worthlessness deductions for business debts that go partially bad.
Key point. Business taxpayers, such as corporations and LLCs, face an easier path to deducting bad debt losses.
But we are going to focus on individual taxpayers here, to keep this from turning into a whole book. You’re welcome!
Non-Business Bad Debt Losses Receive Not-So-Great Tax Treatment
If you, as an individual taxpayer, incur a non-business bad debt loss, it’s treated as a short-term capital loss under the federal income tax rules. Short-term capital losses fall under the dreaded annual limitation on net capital loss
deductions: $3,000 per year, or $1,500 per year if you use married-filing-separate status.
You may be among the many with a significant capital loss carryover from last year’s lousy stock and bond market performances.
You also may have incurred some crypto losses last year, which could create or add to a capital loss carryover.
In this scenario, you could have a long wait before a non-business bad debt loss, piled on top of capital loss carryovers, will actually deliver any tax-saving results for you. Finally, you as an individual taxpayer cannot deduct losses for partially worthless non-business bad debts.
TCJA Sticks It to Losses from Loans to an Employer
If you, as an employee, make a loan to your employer (say, your corporation) that results in a bad debt loss, you are in deep doo-doo thanks to the Tax Cuts and Jobs Act (TCJA).
Before the TCJA, you would have deducted the bad debt as an unreimbursed business expense subject to the 2 percent floor on itemized deductions.
But the TCJA disallows your miscellaneous itemized deductions in total for tax years 2018-2025.
How to Establish the Existence of a Bona Fide Debt
As we said earlier, the first step toward claiming a deductible bad debt loss is proving that the loss was from a bona fide loan transaction that went the wrong way instead of from some other ill-fated financial deal. The courts have supplied some decent guidance on how to establish the existence of a bona fide loan.
- A 2012 Ninth Circuit decision upheld the Tax Court’s use of an 11-factor analysis, developed by the Ninth Circuit itself back in 1970, to evaluate whether shareholder advances to corporations constitute bona fide loans or equity investments.
- A 2006 Sixth Circuit decision used a different 11-factor analysis for the same purpose. We like the Sixth Circuit’s approach better, because it seems more definitive, so we will cover that one in detail. While the Sixth Circuit’s approach deals with how to evaluate purported shareholder loans to a corporation, we can adapt the approach to purported loans by individual taxpayers for various intended purposes.
The Sixth Circuit’s Approach
In its 2006 Indmar Products decision, the Sixth Circuit opined that shareholders’ cash advances to their closely held C corporation were loans that created the bad debt deduction rather than equity investments, based on an evaluation of the following 11 factors.
- Descriptions on documents. If shareholder advances are not described as loans payable on the corporation’s books and as loans receivable in the shareholders’ financial records, the lender-shareholders have hurt their case that the advances are bona fide loans.
- Maturity date and repayment schedule. A fixed maturity date and a defined payment schedule indicate a loan. Repayments of purported loan principal amounts are very persuasive in making the case that shareholder advances are loans. But a fixed maturity date and a payment schedule are not required for a demand loan (one that becomes payable at any time upon the demand of the lender).
- Interest rate and payments. A fixed interest rate indicates a loan. Timely payments of fixed-rate interest persuasively make the case that shareholder advances are loans.
- Source of repayment funds. The Sixth Circuit opined that relying on company profits to generate cash to repay loans is more characteristic of equity. But in the real world, operating profits are often expected to be the main (if not the only) source of funds to repay even unquestionably legitimate third-party loans.
- Debt-to-equity ratio. An excessively high debt-to-equity ratio indicates that shareholder advances may be equity. But this factor is basically moot when the corporation demonstrates a pattern of repaying purported debt principal amounts along with interest.
- Overlap between shareholders and lenders. Purported loans made by shareholders strictly in proportion to their stock ownership interests indicate equity except when there is only one shareholder.
- Security. A lack of adequate security indicates equity.
- Availability of debt financing from outside sources. When a corporation is demonstrably able to obtain third party debt financing if it wishes, shareholder loans are more likely to be seen as legitimate loans.
- Subordination. Subordination of purported shareholder loans to all debt owed to third-party creditors is indicative of equity.
- Use of proceeds. Using the proceeds from shareholder advances to acquire long-term capital assets indicates equity, while using the proceeds for working capital indicates debt. In the real world, however, corporations commonly take out unquestionably legitimate third-party loans to acquire capital assets.
- Sinking fund. The Sixth Circuit opined that the existence of a sinking fund indicates a loan. But the existence of a sinking fund is actually just another form of security, and the security factor was already taken into account in number 7 above. Also, in the real world, many closely held corporations will be unwilling to establish sinking funds even for unquestionably legitimate third-party loans.
“Sinking fund” defined. A sinking fund is a fund set up by a borrower to set aside money over time, which can be used to repay debt at a future date. Instead of waiting until the debt is due, the borrower sets aside a small amount of money regularly into the sinking fund, so that when the debt comes due, the debtor has accumulated enough money to repay it.
For example, let’s say you borrowed $10,000 with a five-year repayment term and an interest rate of 6 percent per year. You could set up a sinking fund to save a portion of the repayment amount every year, so that at the end of the five-year period, you will have saved enough money to repay the full amount.
Distinguishing Business Bad Debts from Non-Business Bad Debts
After establishing that a bona fide debt exists, the second step toward claiming a deductible bad debt loss for an individual taxpayer is determining whether the debt in question was a business debt or a non-business debt.
Identifying Business Bad Debt Losses
As explained earlier, being able to characterize a bad debt loss as a business bad debt loss is preferable. Making that call is easy if the taxpayer is actually in the business of making loans. In other cases, making the call may not be so easy.
According to the IRS, there must be a proximate relationship between your business and the loan for you to claim a business bad debt loss. The Supreme Court has stated that to pass the proximate-relationship test, you must have a dominant business motivation for making the loan. Just a significant business motivation is not enough to pass the test.
It’s easier to pass the proximate-relationship test when the loan is made to support your own business—for example, when a sole proprietor makes a loan to a critically important vendor or customer to help that vendor or customer stay afloat.
Below, we have summarized some illuminating court decisions on the issue of identifying business bad debt losses.
We present our summaries chronologically from the most recent decision to the oldest.
The Owens Decision
The Tax Court concluded that the taxpayer was in the business of lending money during the years in question and that his advances to a business during those years constituted bona fide debts that became worthless in 2008. Therefore, the taxpayer was entitled to the $9.5 million business bad debt loss deduction that he claimed on his 2008 federal income tax return.
In 2002, William Owens, the taxpayer, began a series of loan transactions with Lohrey Investments, a partnership that owned the largest commercial laundry business in the San Francisco Bay Area. Since at least 1986, the taxpayer had made loans for his own account using his personal funds. In late 2008, the laundry business filed for bankruptcy.
Lohrey Investments followed suit. In early 2009, so did David Lohrey, the founder of Lohrey Investments, who had personally guaranteed all of the laundry business’s loans. The bankruptcy proceedings became liquidations, and the taxpayer did not recover anything when the proceedings were finally concluded in 2012.
The $9.5 million business bad debt loss claimed on the taxpayer’s 2008 return resulted in a net operating loss (NOL) that was carried back to 2003-2005 and forward to 2009-2010. After an audit, the IRS denied the bad debt deduction on the grounds that the taxpayer’s lending activity did not amount to a business.
Even if it did, the IRS claimed that the loans were more equity than debt, and that even if they were debt, they did not become worthless in 2008.
The Tax Court opined that the taxpayer had lent from his personal funds for years—regularly, continuously, and with the purpose of making a profit. Therefore, he was in the business of lending money during the years when he made loans to Lowry Investments.
The Tax Court noted that the loans were evidenced by promissory notes that included maturity dates and that the loans became worthless in 2008 when the laundry business filed for bankruptcy and hung Lohrey Investments and David Lohrey out to dry (so to speak).
The fact that the taxpayer ultimately recovered nothing from his ill-fated loans supported the Tax Court’s conclusion that his claimed $9.5 million business bad debt loss deduction and the related NOL carrybacks and carryforwards
were legitimate. So, this was a total taxpayer victory, but it had to be litigated. It did not come cheap!
The Haury Decision
The Tax Court opined that the taxpayer was only entitled to a non-business bad debt loss deduction for worthless loans made to two software development companies. As explained earlier, non-business bad debt loss treatment is generally unfavorable, because the loss is classified as a short-term capital loss subject to the dreaded annual capital loss deduction limitation.
In this case, the taxpayer was a software engineer who managed and held substantial stock ownership interests in the two companies, which were attempting to obtain contracts to develop national alert warning software for the Department of Homeland Security (DHS). The taxpayer withdrew $435,000 from his IRA and transferred the money to the two companies in exchange for interest-bearing promissory notes. The hoped-for DHS contracts never materialized, and the companies were unable to repay the loans.
The Tax Court denied the taxpayer’s business bad debt loss deduction on the grounds that his investments in and management of the companies did not amount to a business.
Instead, according to the court, his dominant motivation for making loans was to protect his stock investments in the companies. To add insult to injury, the taxpayer owed the 10 percent early withdrawal penalty on the taxable portion of the funds withdrawn from his IRA, because he had not reached age 59 1/2.
The Hough Decision
The Seventh Circuit opined that the taxpayer’s advances to a controlled corporation did not result in business bad debt losses. The taxpayer was not determined to be in the business of loaning money or to be in the business of selling corporations that he owned. Therefore, the Seventh Circuit concluded that the taxpayer’s dominant motivation for making the loans was to protect his investment as a shareholder.
Bottom line. In many real-life situations, the facts may not support the taxpayer’s claim that soured debts are business bad debts. In such cases, the losses will be non-business bad debt losses that must be treated as short term capital losses, and the dreaded capital loss deduction limitation will apply.
Tax Planning Strategy: Consider Acquiring Section 1244 Stock Instead of Making a Loan
As a possible alternative to making a risky loan to a small corporation (which may not qualify as a business bad debt if it goes sour), consider making a Section 1244 stock investment. Up to the dollar limits explained below,
Section 1244 stock losses are treated as fully deductible ordinary losses. Needless to say, there are limitations.
- You can claim an ordinary Section 1244 stock loss only if the stock was originally issued to you or to a partnership in which you are a partner. If you acquired the stock by gift or inheritance or by purchasing it from the original holder, you are not eligible for ordinary Section 1244 stock loss treatment. A corporation, trust, or estate cannot qualify for ordinary Section 1244 stock loss treatment regardless of how the stock was acquired.
- The maximum amount that you can claim as an ordinary Section 1244 stock loss in a particular year is $50,000 if you are unmarried or $100,000 on a joint return. Any losses in excess of the annual limitation are treated as capital losses that will, of course, be subject to the dreaded capital loss deduction limitations.
- Both common stock and preferred stock can qualify as Section 1244 stock, and so can S corporation stock.
- You must actually be issued stock for it to qualify as Section 1244 stock. If you simply contribute to the capital of a corporation, any resulting loss will not qualify for ordinary Section 1244 stock loss treatment.
- The determination of whether stock qualifies as Section 1244 stock is made when the stock is issued. Basically, only stock issued for the first $1 million of capital can qualify. For a loss upon the sale or worthlessness of stock to qualify for ordinary Section 1244 stock loss treatment, the corporation must have derived more than 50 percent of its aggregate gross receipts from sources other than investments during the five most recent tax years ending before the date the shareholder’s loss is sustained (or since inception if the corporation has been in existence for less than five years).
Warning. These are not all the rules that apply to Section 1244 stock. Consult your tax advisor for full details before jumping onto the Section 1244 stock bandwagon.
Bottom line. The strategy of contributing capital to a small corporation in exchange for Section 1244 stock (as an alternative to making a risky loan to the same corporation) is not for everyone. Since we are talking about stock, you’ll probably have to give up on the idea that you’ll be able to recover your investment in the near future.
In addition, it may not be possible to receive stock that qualifies as Section 1244 stock—perhaps, for example, because the corporation is already too big.
But the Section 1244 stock strategy is something to consider when the circumstances allow.
This article discusses claiming bad debt loss deductions for individual taxpayers, emphasizing the distinction between business and non-business bad debts. Key takeaways include the following.
Bad debt deduction basics. A deductible bad debt loss must be from a bona fide loan transaction that has become worthless.
Business bad debt losses. These are treated as ordinary losses and can be deducted without limitations. Business taxpayers face an easier path to deducting bad debt losses.
Non-business bad debt losses. These are treated as short-term capital losses and are subject to an annual limitation on net capital loss deductions ($3,000, or $1,500 for married-filing-separate status).
Establishing bona fide debt. Proving that the loss was from a bona fide loan transaction is crucial. Courts have provided guidance through factor analyses.
Distinguishing business from non-business bad debts. A proximate relationship between the business and the loan is required for a business bad debt loss. The Supreme Court states there must be a dominant business motivation for making the loan.
Section 1244 stock. Instead of making a risky loan to a small corporation, consider making a Section 1244 stock investment. You treat Section 1244 stock losses as fully deductible ordinary losses, subject to certain limitations.