It is not uncommon for high-income individual taxpayers to hold uncollectible or worthless business debts. Careful tax planning that maximizes the business bad debt deduction can help minimize the taxpayer's overall economic loss.Establishing a Bona Fide Debt With a Related Business
A bona fide debt is one arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money (Regs. Sec. 1.166-1(c)). The taxpayer must be able to show that it was the intent of the parties at the time of the transfer to create a debtor-creditor relationship. In other words, the taxpayer must be able to show that at the time of the transaction, he or she had a real expectation of repayment and there was an intent to enforce the indebtedness. A formal loan agreement is not absolutely necessary to create a bona fide debt. Also, the giving of a note or other evidence of legally enforceable indebtedness is not in itself conclusive evidence of a bona fide debt.
The fact that the debtor is a related business does not preclude a bad debt deduction by the individual taxpayer. If owner or related-party loans made for legitimate business purposes become worthless, they are treated no differently than debts to an unrelated party are. Of course, this assumes that the loans meet the bona fide standard (i.e., a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money). Debts between related parties are generally subject to closer scrutiny than other debts.Distinguishing Business From Nonbusiness Bad Debts
Two types of bad debt deductions are allowed under Sec. 166: business bad debts and nonbusiness bad debts. Business bad debts give rise to ordinary losses, while nonbusiness bad debts give rise to short-term capital losses (Secs. 166(a) and (d)). Because of the limitation on capital losses, distinguishing business and nonbusiness bad debts is critical.
A business bad debt often originates as a result of credit sales to customers for goods sold or services provided. If a sole proprietor sells goods or services on credit and the account receivable subsequently becomes worthless, a business bad debt deduction is permitted, but only if the income arising from the creation of the receivable was previously included in income (Regs. Sec. 1.166-1(e)). Thus, for cash-basis taxpayers, a bad debt deduction is generally not allowed for uncollectible accounts receivable since these items are normally not included in income until received.
Business bad debts can also take the form of loans to suppliers, clients, employees, and distributors. Additionally, a guarantor is allowed a business bad debt deduction for any payment made in the capacity as guarantor if the reason for guaranteeing the debt was business. Here, the guarantor's payment results in a loan to the debtor, and the taxpayer is allowed a bad debt deduction once the loan (including any right of subrogation against the debtor) becomes partially or totally worthless (Regs. Sec. 1.166-9(e)(2)).
Note: To claim a loss deduction, a taxpayer making payment on a loan guarantee that becomes unrecoverable (i.e., worthless) must receive reasonable consideration for entering into the guarantee agreement. For the guarantee of a non—family member's debt, consideration can be either direct (i.e., cash or property) or indirect. Indirect consideration is determined in accordance with normal business practice and, for example, may be in the form of improved business relationships. For the guarantee of a family member's debt, however, the consideration must be direct (i.e., cash or other property) (Regs. Sec. 1.166-9(e)(1)).
Loans to businesses owned by the taxpayer can also generate business bad debts if the loans were made to preserve the taxpayer's employment status and income earning potential, or in the course of the taxpayer's business of buying and selling businesses. Debts that do not qualify as business bad debts are nonbusiness bad debts (or possibly gifts).
In distinguishing business and nonbusiness bad debts, the question that must be asked is: Does the loss bear a "proximate" relation to the taxpayer's trade or business? If so, the regulations state that the debt qualifies as a business bad debt (Regs. Sec. 1.166-5(b)). However, the Supreme Court has taken it a step further and held that, in determining whether the relation is proximate, the dominant motivation for making the loan must be business-oriented (Generes, 405 U.S. 93 (1972)). Significant motivation between the debt and the taxpayer's business does not satisfy this requirement.
Example 1. Business bad debt for loan to supplier: S, a sole proprietor, operates a retail store. He guaranteed payment of a $10,000 note of his best supplier, who is also a close friend, in an effort to ensure that the supplier continued in business. The supplier later filed for bankruptcy and defaulted on the note. S was forced to make full payment under his guarantee. His efforts to recover his guarantee payment proved unsuccessful.
It appears S's bad debt loss is considered a business bad debt since his guarantee was spurred by his business motive to retain his best supplier. The close personal friendship between S and his supplier does not affect the business nature of the bad debt loss if the facts show the dominant motivation for the loan was business. The guarantee can thus be considered closely related to his business and gives rise to a business bad debt.
A taxpayer who can establish that he or she is in the trade or business of lending money normally can claim a business bad debt deduction for uncollectible loans. In determining whether the taxpayer is in the trade or business of lending money, the courts generally consider: (1) the total number of loans made; (2) the time period over which the loans were made; (3) the adequacy and nature of the taxpayer's records; (4) whether the loan activities were kept separate and apart from the taxpayer's other activities; (5) whether the taxpayer sought out the lending business; and (6) the amount of time and effort expended in the lending activity and the relationship between the taxpayer and his debtors (Henderson, 375 F.2d 36 (5th Cir. 1967); Serot, T.C. Memo. 1994-532, aff'd, 74 F.3d 1227 (3d Cir. 1995)).Proving Worthlessness
The worthlessness of a debt is a question of fact. All pertinent evidence should be considered, including the value of any collateral and the financial condition of the debtor (Regs. Sec. 1.166-2(a)). Proof of worthlessness is best established by an identifiable event demonstrating the loss of value for the debt.
Example 2. Proof of worthlessness: W is a sole proprietorship selling sophisticated security systems. It uses the accrual method of accounting. In March 2015, it sold $25,000 of security equipment to a retail store for $5,000 down and the balance due in 90 days. When the balance became due, W found that the customer had closed its doors, and the owner could not be located. Subsequent correspondence was returned by the post office.
The cessation of business by the customer is an identifiable event that established proof of worthlessness of the amount due from the customer. Therefore, W should be entitled to a $20,000 bad debt deduction in 2015. (The income would have been booked at the time of the sale since W is an accrual-method business.)
Worthlessness can be established when the taxpayer sues the debtor, wins a judgment, and then shows the judgment is uncollectible. However, when the surrounding circumstances indicate that a debt is worthless and uncollectible, and that legal action to collect the debt would in all probability not result in collection, proof of these facts is sufficient to justify the deduction (Regs. Sec. 1.166-2(b)).
Evidence that a debtor is experiencing financial difficulties will not by itself support an argument for worthlessness. The debtor's bankruptcy, however, generally does indicate that an unsecured business debt is at least partially worthless (Regs. Sec. 1.166-2(c)). Thus, retaining a copy of the bankruptcy notice should support at least a partial reduction in the value of a receivable or other noncollateralized debt due from the bankrupt business.
- The disappearance or death of an individual debtor (documented by a newspaper clipping, return mail marked deceased, etc.);
- The uncollectibility of a deficiency after the property securing the debt is sold;
- A writ of execution returned by the sheriff with the notation "no property found" or "not satisfied"; or
- The worthlessness of a judgment against the debtor.
Observation: Absent any of these items as proof, a taxpayer's best documentation is likely to be a detailed record of collection efforts. The record should indicate that the business made every effort a reasonable person would take to collect a debt. However, as noted previously, the taxpayer is not required to actually file a judgment against the debtor if, based on the facts, this action obviously would not improve the collection effort's success.When to Claim a Business Bad Debt Deduction
A business bad debt can be either partially or totally worthless. If the taxpayer can collect some, but not all, of the debt, it has a partially worthless debt (Sec. 166(a)(2)). If the taxpayer cannot collect any of the remaining amount of a debt, even if it collected some of it in the past, the taxpayer has a totally worthless bad debt (Sec. 166(a)(1)). All taxpayers, except for certain financial institutions, use the specific charge-off method to deduct business bad debts as they become partially or totally worthless.
Before the taxpayer can deduct a partially worthless business debt, it must be able to show that partial worthlessness has occurred and the amount of partial worthlessness that has been charged off on the books of the business. The taxpayer may choose from among the following options concerning how to handle the debt for tax purposes (Regs. Sec. 1.166-3(a)):
- The taxpayer may claim a deduction for any portion of the debt, up to the amount actually written off its books during the year. The requirement to record a book charge-off means the portion charged off must no longer appear as an asset in the business's financial records or on its financial statements. However, it does not mean the business must cancel the debt or notify the debtor of the charge-off. Thus, the taxpayer may still continue its collection efforts while claiming a tax deduction for a partially worthless debt.
- The business can always forgo a current-year tax deduction in favor of waiting until the balance of the debt is either collected or determined to be worthless. It can claim a bad debt deduction for the entire uncollected amount at that time.
Example 3. Deducting a partially worthless debt: C owns and operates an accrual-method sole proprietorship selling computer equipment. The business has a note receivable from a customer with a balance of $30,000. The customer is having financial problems. In 2015, after repeated collection attempts, C determines $20,000 of the receivable is uncollectible and writes off this amount on the business's books. The remaining $10,000, which C is confident of someday receiving, is left on the books.
For tax purposes, C may take a bad debt deduction in any amount up to $20,000 in 2015. Alternately, she may wait until the balance of the debt is either collected or determined to be worthless and claim a bad debt deduction for the entire uncollected amount at that time.
A totally worthless debt is deductible only in the tax year it becomes totally worthless. The deduction for the debt does not include any amount deducted in an earlier year when the debt was only partially worthless (Regs. Sec. 1.166-3(b)).
Caution: The business is not required to make an actual charge-off on its books to claim a bad debt deduction for a wholly worthless debt. However, it may want to do so in case the IRS later asserts the debt was only partially worthless and disallows even a partial deduction since no charge-off occurred. (A deduction for a partially worthless debt is limited to the amount actually charged-off on the business's books.)
Note: It is sometimes difficult to prove that a debt became worthless in a particular year. If the IRS later maintains worthlessness occurred in a year earlier than the one in which the deduction is taken, the deduction may be lost because the statute of limitation for filing a refund claim has expired. For this reason, the IRS extends the statute of limitation for claiming a credit or refund for bad debts to seven years, rather than the usual three years (Sec. 6511(d)). If any doubt exists as to the proper tax year to claim a bad debt deduction, claiming the deduction in the earliest year it could possibly be allowed is recommended. The claim should be reviewed in a subsequent year (and an amended return filed for the original year) if facts develop to indicate a later year is the proper one for claiming the deduction.
This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 16th edition, by Anthony J. DeChellis and Patrick L. Young, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.