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You may contact Bob Parrish by email, USA Mail, Fax, telephone or request a meeting The Question: Can I write-off a loan I made to someone that is not repaid? This had nothing to do with my business. Bad Debts; Bankruptcy ~ Pre-petition Planning; Bankruptcy - Typical Forms; Bankruptcy ~ Planning For the Initial Attorney Conference |
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SummaryBUSINESS VERSUS NON-BUSINESS BAD DEBTS The distinction between business and non-business bad debts is important in determining their tax treatment. Business bad debts are fully deductible against ordinary income. Code Section 166(a)(1), 166(d)(1)(B). Non-business bad debts are deductible by individual taxpayers only as short-term capital losses. Code Section 166(d)(1). In addition, certain business bad debts may be deductible when they become partially worthless, but non-business bad debts are deductible only when they become totally worthless. Code Section 166(a)(2), 166(d)(1)(A).
A non-business bad debt is defined by what it is not: A non-business bad debt is any debt other than one created or acquired in connection with the taxpayer's trade or business or one that, when worthless, creates a loss that is incurred in the taxpayer's trade or business. Code Section 166(d)(2). A non-business bad debt may arise from many types of transactions, a few examples are:
If you take a tax deduction for the bad debt, you should be in a position to substantiate the claims and statements on your tax return: THE DEBT: You must have documents signed by all parties showing agreement a debt was intended and which meet the essential elements of a contractual debt. The documents must meet all the requirements and compliance issues of the state in which the debt was established. Furthermore the debt must place in writing the following:
Other elements should be considered essential for the protection of all parties:
Furthermore the IRS has made its position clear regarding essential elements of a promissory note: The following factors are significant in making the debt/equity determination in this case. 1. Maturity Date. Perhaps the most important factor in characterizing a corporate obligation as a debt instrument is a fixed maturity date. Under the terms of the note, you must be unconditionally entitled to require the note to be repaid at the final maturity date. The facts that the Company may repay its obligation before that time further supports a debt characterization. 2. Right to Accelerate. You must have the right to accelerate the final maturity date in the event the Company is in default. Moreover, the parties must act like debtor and creditor. Your actions in enforcing the note are as important as its formal terms in characterizing the obligation. 3. Economic Risk. Would a reasonable unrelated creditor make the loan on the same terms and conditions? In evaluating the economic risks, creditors (and the courts) look to the ratio of the borrower's debt to its equity and the expected source for repayment of the advance. The annual (rather than monthly) interest and balloon payment increase the economic risk associated with the loan. Protective provisions, such as securing the obligation of providing for a sinking fund, on the other hand, might offset such risk. 4. Rights to Income. The interest on the note must reflect an arm's length rate. The fact that a potion of the interest is payable only if it is earned is an indication of equity. That alone, however, should not impair the debt status since the payment is not subject to any discretionary action by the Company. If the contingent payments are merely additional compensation for the use of money, the entire arrangement may be recognized as debt. On the other hand, if the fixed interest (at prime) is adequate, the IRS might try to bifurcate the note into a fixed interest debt and a separate "equity kicker." 5. Subordination. While subordination of the note to the Company's senior debt is an equity factor, it is not fatal to a debt characterization absent other substantially adverse factors. To the extent possible, however, the notes should not be subordinated to the general creditors of the Company. 6. Convertibility. Convertible debt is generally treated as debt until it is converted. However, where there is a high probability of conversion, the conversion feature may evidence an intention to create an equity interest rather than a debt. 7. Labels. Although not determinative, it is important that the advance be called a debt and that both parties treat it as such on their books and records. 8. Use of Funds. Some courts also look to the use of the funds, on the theory that assets essential to the business should be acquired with equity capital. There should be only one set with original signatures. The original signatures will be kept in safe keeping by the creditor. THE DEBTOR: The debtor must be identified and an original signature copy of the promissory note must be in the possession of the creditor. RELATIONSHIPS: If there is any blood or financial relationship between the debtor and the creditor those relationships must be identified in the statements attached to your tax return. COLLECTION EFFORTS: If the creditor has not made all legal efforts to collect the debt, the bad debt write-off might be disallowed. Therefore, the creditor must be willing to engage an attorney to collect the debt and sue for it if not paid. If the debtor has declared bankruptcy the creditor must have submitted a claim to the bankruptcy court and retain those records of claims. EXPLANATION OF FAILURE TO COLLECT: The taxpayer/creditor must attach to the tax return a statement or explanation a statement what efforts to collect the tax have been undertaken and why those efforts were not successful. Bad debts - Nonbusiness RulesIN GENERAL
The distinction between business and non-business bad debts is important in determining their tax treatment. Business bad debts are fully deductible against ordinary income. Code Section 166(a)(1), 166(d)(1)(B). Non-business bad debts are deductible by individual taxpayers only as short-term capital losses. Code Section 166(d)(1). In addition, certain business bad debts may be deductible when they become partially worthless, but non-business bad debts are deductible only when they become totally worthless. Code Section 166(a)(2), 166(d)(1)(A). TIP: An individual taxpayer deducts a bad debt from operating a trade or business on line 9 of Schedule C, Form 1040, or line 2 of Schedule C-EZ, Form 1040. A bad debt from operating a farm business is deducted on line 34 of Schedule F, Form 1040. A taxpayer deducts non-business bad debts as short-term capital losses on Schedule D, Form 1040, and must attach a statement describing the debt, naming the debtor and any relationship with the debtor, listing any efforts made to collect the debt, and explaining why the taxpayer decided the debt was worthless. A non-business bad debt is defined by what it is not: A non-business bad debt is any debt other than one created or acquired in connection with the taxpayer's trade or business or one that, when worthless, creates a loss that is incurred in the taxpayer's trade or business. Code Section 166(d)(2).
INVESTOR BAD DEBTS Investing is not considered a trade or business. <29> A shareholder in a corporation is an investor and is generally not attributed the trade or business of the corporation, even if the shareholder is the sole shareholder and devotes his time and energies to the affairs of the corporation. <30> Although such activities may produce income in the form of dividends or an increase in the value of the taxpayer's investment, the income is generated by the corporation's trade or business rather than by a trade or business of the taxpayer. Whipple v. Commissioner, 373 U.S. 193, reh'g denied, 374 U.S. 858 (1963). The Eleventh Circuit has affirmed a Tax Court decision holding that where a taxpayer advanced money to his wholly owned corporation and the liability was later cancelled as part of the sale of the corporation, the amount advanced was a capital contribution rather than a loan, and the taxpayer was not entitled to a business bad debt deduction. Plante v. Commissioner, 168 F.3d 1279 (11th Cir. March 5, 1999). Thus, an individual shareholder's loan to a corporation is not considered a business bad debt unless the shareholder shows the debt is proximately related to the shareholder's own business. This generally means that the shareholder must prove that she is in the trade or business of lending money or that the corporation is the shareholder's customer, supplier, client, or tenant, or can otherwise provide useful contacts with prospective customers. A shareholder's loan to a corporation may be a business bad debt if the taxpayer is in the business of promoting, financing, and selling corporations. <31> Even investing in eight or nine corporations over a five-year period does not prove that the taxpayer is in the business of financing and promoting corporations. <32> A shareholder-employee who lends money to or guarantees a debt of the corporation similarly may treat the debt as a business debt only if the loan is proximately related to his business of being an employee, such as where the employee makes the loan to retain his job. <33> To be proximately related to the taxpayer's employment, the employment must be the dominant motive for the loan, which can be difficult to establish if the employee is also the sole or dominant shareholder of the corporation. Which motive dominates depends primarily on the amount of salary as compared to the amount invested. For example, protection of his employment was not the dominant motive of a part-time president with a $12,000-a-year salary and a 44 percent interest in the corporation where the taxpayer paid $160,000 under his indemnity on the corporation's default. United States v. Generes, 405 U.S. 93, reh'g denied, 405 U.S. 1033 (1972). TIP: The bad debt deduction arising under these circumstances is reported as an unreimbursed employee business expense on Schedule A of Form 1040, subject to the 2 percent of AGI limitation. IRS Publication 529, Miscellaneous Deductions. OBSERVATION: The IRS position in Publication 529 is based on Code Section 62(a)(1); that section provides that expenses incurred by an individual in the business of performing services as a an employee may not be taken into account in computing adjusted gross income. According to the IRS this overrides Code Section 62(a)(3), which provides that bad debts are deductible in arriving at adjusted gross income. Other sources of gross income available to the taxpayer at the time of the loan or guaranty, as well as comparison of the risk of the loan to the creditor's investment, are also factors considered in determining the taxpayer's dominant motive. If the creditor has substantial income supplements from other sources, the loan may be considered investment motivated. Conversely, where the amount at risk greatly exceeds the amount of the investment, the loan cannot be justified as an enhancement to the investment. Garner v. Commissioner, 987 F.2d 267 (5th Cir. 1993); Litwin v. United States, 983 F.2d 997 (10th Cir. 1993). Further, where the taxpayer's return on his loan to the corporation is realized in increased salary rather than an increased stock value, employment is likely the dominant motive. Smartt v. Commissioner, T.C. Memo. 1993-65. OBSERVATION: Similarly, an owner or shareholder of a small business will often act as guarantor of some indebtedness of her business. A showing that her company is her main source of livelihood, and has been over the years, will generally persuade a court that the dominant motive in guaranteeing the debt was to protect her income. Rosenberg v. United States, No. 94 C 5978 (N.D. Ill. Aug. 20, 1996). A loan by an employee to an employer was a business bad debt where the loans were made by a sales manager, stylist, and designer to enable the employer to complete contracts for shoes he had designed and sold and to protect his reputation and employability as a shoe designer and salesman. Artstein v. Commissioner, T.C. Memo. 1970-220. In order to make this argument, however, the taxpayer must be seeking something other than a mere investor's return. To qualify, the taxpayer must seek fees, commissions, or sales profits (and not just dividends), her activities must be frequent and continuous, and the dominant motive for the loans must be connected with promoting the business. United States v. Generes, 405 U.S. 93, reh'g denied, 405 U.S. 1033 (1972). , T.C. Memo. 1970-220. In order to make this argument, however, the taxpayer must be seeking something other than a mere investor's return. To qualify, the taxpayer must seek fees, commissions, or sales profits (and not just dividends), her activities must be frequent and continuous, and the dominant motive for the loans must be connected with promoting the business. United States v. Generes, 405 U.S. 93, reh'g denied, 405 U.S. 1033 (1972). A taxpayer may engage in more than one business at a time (Omaha National Bank v. Commissioner, 183 F.2d 899 (8th Cir. 1950) and the promoter's main business efforts and primary income need not be derived from his business as a promoter in order to qualify for a business bad debt deduction. Farrington v. United States, 111 B.R. 342 (Bankr. N.D. Okla. 1990), aff'd, 91-1 U.S.T.C. para. 50,115 (Bankr. N.D. Okla. 1991). But see In re De Lisser, 90-2 U.S.T.C. para. 50,352 (Bankr. N.D. Tex. 1990) (a business must be pursued full time to qualify for a business bad debt deduction). A taxpayer's claim that he was entitled to Code Section 1244 ordinary loss treatment on the sale of his stock in one of the corporations undermined his argument that he considered himself as being in the trade or business of financing and promoting small business, since claiming the Code Section 1244 ordinary loss strongly indicated that the taxpayer actually viewed himself as an investor. <34> <Citations> 24/ See Kertes v. Commissioner, T.C. Memo. 1962-158. 25/ See Markovits v. Commissioner, 11 T.C.M. 823 (1952). 26/ See Bart v. Commissioner, 21 T.C. 880 (1954). 27/ See Whipple v. Commissioner, 373 U.S. 193, reh'g denied, 374 U.S. 858 (1963). 28/ Brenhouse v. Commissioner, 37 T.C. 326 (1961); Butler v. Commissioner, 36 T.C. 1097 (1961). 29/ Whipple v. Commissioner, 373 U.S. 193, reh'g denied, 374 U.S. 858 (1963); Higgins v. Commissioner, T.C. Memo. 1976-220. But see Omaha National Bank v. Commissioner, 183 F.2d 899 (8th Cir. 1950) (taxpayer who devotes the major portion of his time to stock market speculation may treat losses thus incurred as having been sustained in the course of a trade or business). 30/ Vreeland v. Commissioner, 31 T.C. 78 (1958); Manti v. Commissioner, 11 T.C.M. 1137 (1952). 31/ United States v. Generes, 405 U.S. 93, reh'g denied, 405 U.S. 1033 (1972); Trent v. Commissioner, 291 F.2d 669 (2d Cir. 1961). See also Whipple v. Commissioner, 373 U.S. 193 (1963), reh'g denied, 374 U.S. 858 (1963); Loventhal v. United States, 478 F.2d 311 (6th Cir. 1973). See also Litwin v. United States, 983 F.2d 997 (10th Cir. 1993), where the taxpayer was allowed an ordinary loss as a business bad debt for the money that he lent to his corporation. The Tenth Circuit concluded that a taxpayer may have an employment-related motive for making a loan even though it might operate to increase the value of the taxpayer's investment rather than his salary. See also Baldwin v. Commissioner, T.C. Memo. 1993-433 (taxpayer entitled to ordinary loss for loans to his corporation that subsequently became worthless; taxpayer's dominant motive in making the loans was to secure his salary and bonuses and his continuing employment with the corporation). 32/ Whipple v. Commissioner, 373 U.S. 193, reh'g denied, 374 U.S. 858 (1963); Nichols v. Commissioner, 29 T.C. 1140 (1958); Ferguson v. Commissioner, 16 T.C. 1248 (1951). 33/ See Whipple v. Commissioner, 373 U.S. 193, reh'g denied, 374 U.S. 858 (1963) ("If full-time service to one corporation does not alone amount to a trade or business, which it does not, it is difficult to understand how the same service to many corporations would suffice"). 34/ Frantz v. Commissioner, 784 F.2d 119 (2d Cir. 1986), cert. denied, 483 U.S. 1019 (1987) But see Farrington v. United States, 111 B.R. 342, 90-1 U.S.T.C. para. 50,125 (Bankr. N.D. Okla. 1990), aff'd, 91-1 U.S.T.C. para. 50,115 (Bankr. N.D. Okla. 1991) (the presumption a taxpayer claiming a Code Section 1244 deduction considers herself an investor, as set forth in Frantz, is unwarranted where evidence indicates the taxpayer/investor was in business as a promoter). See Ch. 76 for a detailed discussion of Code Section 1244. SECTION 1.166-2. EVIDENCE OF WORTHLESSNESS. (a) GENERAL RULE. In determining whether a debt is worthless in whole or in part the district director will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. (b) LEGAL ACTION NOT REQUIRED. Where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of these facts will be sufficient evidence of the worthlessness of the debt for purposes of the deduction under section 166. (c) BANKRUPTCY-- (1) GENERAL RULE. Bankruptcy is generally an indication of the worthlessness of at least a part of an unsecured and unpreferred debt. (2) YEAR OF DEDUCTION. In bankruptcy cases a debt may become worthless before settlement in some instances; and in others, only when a settlement in bankruptcy has been reached. In either case, the mere fact that bankruptcy proceedings instituted against the debtor are terminated in a later year, thereby confirming the conclusion that the debt is worthless, shall not authorize the shifting of the deduction under section 166 to such later year.
SECTION 1.166-5. NONBUSINESS DEBTS. (a) ALLOWANCE OF DEDUCTION AS CAPITAL LOSS.
(b) NONBUSINESS DEBT DEFINED. For purposes of section 166 and this section, a nonbusiness debt is any debt other than--
The question whether a debt is a nonbusiness debt is a question of fact in each particular case. The determination of whether the loss on a debt's becoming worthless has been incurred in a trade or business of the taxpayer shall, for this purpose, be made in substantially the same manner for determining whether a loss has been incurred in a trade or business for purposes of section 165(c)(1). For purposes of subparagraph (2) of this paragraph, the character of the debt is to be determined by the relation which the loss resulting from the debt's becoming worthless bears to the trade or business of the taxpayer. If that relation is a proximate one in the conduct of the trade or business in which the taxpayer is engaged at the time the debt becomes worthless, the debt comes within the exception provided by that subparagraph. The use to which the borrowed funds are put by the debtor is of no consequence in making a determination under this paragraph. For purposes of section 166 and this section, a nonbusiness debt does not include a debt described in section 165(g)(2)(C). See Section 1.165-5, relating to losses on worthless securities. (c) GUARANTY OF OBLIGATIONS. For provisions treating a loss sustained by a guarantor of obligations as a loss resulting from the worthlessness of a debt, see Sections 1.166-8 and 1.166-9. (d) EXAMPLES. The application of this section may be illustrated by the following examples involving a case where A, an individual who is engaged in the grocery business and who makes his return on the basis of the calendar year, extends credit to B in 1955 on an open account:
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7657, 44 FR 68464, Nov. 29, 1979; T.D. 7728, 45 FR 72650, Nov. 3, 1980]
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