The issue of whether or not an individual can deduct “bad debts” related to monies loaned to his/her own business or businesses owned by others has been a point of contention between the Internal Revenue Service (IRS) and taxpayers for many years.  As our economy continues to struggle and an air of uncertainty remains, many taxpayers, individuals and businesses alike, are finding it increasingly more difficult to make ends meet.  They turn to friends and relatives for a source of funds to keep their businesses afloat.  Some have been able to turn things around.  Unfortunately, others have had to close their doors.  When the “out of business” sign goes up, many of those friends and relatives that provided the last lifeline of cash are left wondering if they are entitled to a tax deduction for their losses.  The question becomes: “Do I have a bad debt or did I make a bad decision”?

A wise colleague believes the answer to every tax question is “It depends”.  In this case, he is right again.  In order to claim a deduction for a bad debt loss depends on whether the loss resulted from a bona fide loan, an equity investment or nothing more than an unintended gift.  The individual taxpayer has the burden of proof to establish the nature of the deduction.  But that is only the first hurdle.  If a taxpayer can establish the existence of bona fide debt, they must then determine whether it was a “business bad debt” or a “non-business bad debt”.  This distinction is very important:  business bad debts are deductible as ordinary losses, without any limitations and can be partially written off if the facts can establish that only a portion of the debt is unrecoverable.  Non-business bad debts on the other hand are treated as short-term capital losses, limited by the $3,000 excess capital loss limitation rule and must be fully worthless before any deduction is allowed.

How does a taxpayer establish the existence of a bona fide loan?  Several factors must be analyzed, with no one being determinative.  The factors should be evaluated collectively.  In essence, before it can be a loan it has to look like a loan and smell like a loan!  The key factors to be considered include: 

• Description on Documents:  Does the corporation’s books refer to the “Loan Payable” or “Notes Payable”?
• Maturity Date and Repayment Schedule:  The presence of a fixed maturity date and an amortization schedule for payments are indicative of debt.  Actual repayments pursuant to the amortization schedule.  For demand notes however, these are not required;
• Interest Rate and Payments:  The presence of a fixed rate of interest and actual timely payments are evidence of a debt obligation;
• Source of Repayment Funds:  if the business had to rely on profit generation in order to make timely payments of principal and interest, then this will be more indicative of equity rather than debt;
• Debt-to-equity ratio:  a high debt-to-equity ratio, especially with absence of repayments, is more indicative of equity than debt;
• Overlap between Shareholders and Lenders:  Monies advanced to a corporation by shareholders in proportion to their stock ownership percentage typically indicates equity rather than debt;
• Security:  a lack of adequate security or collateral might be indicative of equity;
• Availability of Debt Financing from Unrelated Parties:  if the corporation has demonstrated the ability to secure financing from unrelated parties when it wishes, shareholder advances to the corporation are more likely to be considered debt rather than equity
• Subordination:  if amounts advanced by a shareholder to the corporation are subordinated to all other debt owed by the corporation, the advance is more likely to be treated as equity
• Use of Proceeds:  the courts have looked to the use of proceeds for working capital needs as evidence of debt, while use of proceeds for long-term capital assets as evidence of equity.  This factor is often debated as it is common practice for corporations to obtain unrelated financing for long-term capital assets.

The nature and content of the documentation is critical to establish a true debtor-creditor relationship.  Documentation is even more important in the case with transactions between family members.   Those types of transaction receive close scrutiny from the IRS and are generally presumed to be gifts unless it can be established that a bona fide loan exists.

After weighing all the factors collectively, if the evidence indicates bona fide debt exists, the first hurdle has been cleared.  The final hurdle requires a determination of whether the debt is business or non-business debt, as the classification determines the nature of the deduction (ordinary loss vs. capital loss).   Under the Internal Revenue Code (IRC), a business bad debt arises from either (1) a debt created or acquired in the ordinary course of the taxpayer’s business (such as an accounts receivable), or (2) a worthless debt, the loss from which is incurred in the taxpayer’s trade or business.  

In determining whether a bad debt was incurred in the taxpayer’s trade or business, there must be a proximate relationship between the taxpayer’s business and the loan.  The Supreme Court, in several cases, has held that in order to have a proximate relationship, the dominant motivation for making the loan must be business oriented.  Since the terms “proximate relationship” and “dominant motivation” are not defined in the IRC or the regulations, the ultimate determination is often one of facts and circumstances.

Despite the above, a “business” bad debt does not necessarily have to be incurred in connection with the taxpayer’s own trade or business.  The taxpayer may establish that a loan to another business is a business loan if it was made to protect the taxpayer’s status as an employee, source of income, business relationship or reputation.

In summary, if you are called upon to loan money to your business or perhaps to help that friend or relative keep their business afloat, proper documentation can help preserve the most advantageous tax result in the event of default.  Before entering into any such transaction, please remember to consult with your Dermody, Burke & Brown tax advisor.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.