Business and Nonbusiness Bad Debts

Preface: In the long run we shall have to pay our debts at a time that may be very inconvenient for our survival. — Norbert W.

Business and Nonbusiness Bad Debts

It is virtually inevitable that at one time or another some taxpayers will incur financial investment losses either in business or personal lives. One frequently occurring type of loss is a bad debt. Whether made in the course of business, or to a friend or relative, sometimes a loan simply cannot be repaid despite the best intentions of the debtor, and if there is little or no prospect that repayment can be made in the future.  In those cases, a “bad debt” may exist for tax purposes. The issue then becomes whether you can salvage some tax benefit from not being repaid.  Although this subject is fraught with complexities, we have outlined the basic tax principles below so you may consider your options.

The first step is ascertaining that a real debt exists. There must be a valid and legally enforceable obligation to pay you a fixed or “determinable” sum of money. Loans between family members, or other related parties such as corporations and their shareholders, are particularly scrutinized to make sure that they are really debts rather than disguised gifts, dividends, or contributions to the corporation’s capital. Therefore, if you are contemplating a loan to a related party, you must ensure that you treat the transaction as a true loan by taking the steps that an arm’s-length lender would take, such as putting it in writing and charging a reasonable rate of interest.

Secondly, it then must be determined if, and when, the debt has become totally or partially worthless. If so, that is a bad debt. One problem, however, is that the IRS often requires taxpayers to play a guessing game. A taxpayer might claim a bad debt loss when nonpayment is only probable, rather than a virtual certainty, and then the IRS may disallow the loss as premature because there is some possibility of repayment in a later year. On the other hand, if the taxpayer waits until repayment is clearly hopeless, the IRS may maintain that the debt was really worthless in a prior tax year and determine that the loss should have been taken then. Because of potential statute of limitations problems, we generally recommend that the loss be claimed in the earliest possible year that it can reasonably be argued to be worthless. There are a number of facts which might indicate worthlessness, including the debtor’s bankruptcy, but no one of them is decisive; it is the totality of circumstances that is determinative.

Once you have established that a bad debt exists, you must also determine whether that debt had a business or nonbusiness nature. The specific tax deduction to which you may be entitled often hinges upon this characterization. As you might expect, a business bad debt must be created or acquired, or become worthless, in the course of your trade or business. If you conduct a business in the form of a corporation, generally any debt held by the corporation is a business debt. Any debt not falling into the business category is a nonbusiness debt. A nonbusiness debt must be completely worthless before a loss can be taken, whereas a loss on a business bad debt can be taken when partial worthlessness can be established. Furthermore, nonbusiness bad debts are subject to the limitations on capital losses. Business bad debts, on the other hand, are deductible as ordinary losses in full against your other income.

As we said above, this is a complex topic and the preceding discussion can give only a rudimentary overview of all of the tax rules involved. If you are, or may be in a situation where these rules could affect you, please do not hesitate to contact us.

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