Carol McAtee & Associates
This week, we would like to share some valuable information for you in the event you are considering claiming a bad debt deduction…
Claiming Bad Debt Deductions
The tax treatment of a worthless debt instrument or loan turns on whether the worthless loan is characterized as a business bad debt or a non-business bad debt. From a tax perspective, characterization of a bad debt as a business bad debt is preferable because a qualifying business bad debt is fully deductible under Code Sec. 166(a), whereas a non-business bad debt is deductible only as a short-term capital loss subject to the $3,000-per-year limitation for capital losses [Code Sec. 166(d)(1)]. A short-term capital loss offsets short-term capital gain, with any excess used to offset long-term capital gain. When short-term capital losses exceed capital gain, the excess can only offset up to $3,000 of ordinary income in the year the loss occurs. Any unused balance of the short-term capital loss can be carried over to subsequent tax years (Code Secs. 1211, 1212 and 1222).
An uncollectible loan will constitute a deductible business bad debt if the debt was bona fide, arose from a debtor-creditor relationship and was based on a valid and enforceable obligation to pay a fixed or determinable amount of money, and if the intent of the parties at the time of the transfer was to create a debtor-creditor relationship [Code Sec. 166(d)(2)(A)]. In addition, the debt must become either wholly or partially worthless in the year for which a deduction is claimed, and must constitute either a bona fide debt created or acquired in connection with the taxpayer’s trade or business, or a debt for which the loss from worthlessness is incurred in the taxpayer’s trade or business [Code Sec. 166(d)(2); Reg. §1.166-5(b)]. Code Sec. 166(d)(2) defines a non-business bad debt as a debt other than one created or acquired in connection with the taxpayer’s trade or business, or the loss from worthlessness incurred in the taxpayer’s trade or business.
“Bona Fide Debt” Defined
In order for a loan to constitute a bona fide debt for purposes of Code Sec. 166, at the time the funds are transferred, a valid, bona fide enforceable debt must exist. A bona fide debt is defined as a debt arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money. Note that a gift or contribution to capital will not be considered a debt for purposes of claiming a bad debt deduction [Reg. §1.166-1(c)].
A debt is bona fide if there is an unconditional obligation on the part of the transferee to repay and an unconditional intention on the part of the transferor to secure repayment of the funds. Whether a transfer of funds constitutes a loan may be inferred from objective characteristics surrounding the transfer, including the following:
• The presence or absence of a debt instrument, collateral securing the purported loan, interest accruing on the purported loan, repayments of the funds transferred and a fixed schedule for repayments of the funds transferred
• Any other attributes indicative of an enforceable obligation to repay the funds transferred
• Whether the alleged borrower has the ability to repay the alleged loan at the time the alleged lender transfers the funds
The courts have identified and considered the following 13 factors to use in determining whether a bona fide debt exists:
• The names given to the certificates evidencing the indebtedness
• The presence or absence of a fixed maturity date
• The source of payments
• The right to enforce payment of principal and interest
• Participation in management flowing as a result
• The status of the contribution in relation to regular corporate creditors
• The intent of the parties
• “Thin” or inadequate capitalization
• Identity of interest between creditor and stockholder
• Source of interest payments
• The ability of the corporation to obtain loans from outside lending institutions
• The extent to which the advance was used to acquire capital assets
• The failure of the debtor to repay on the due date or to seek a postponement
“Worthlessness” Defined
Whether a debt is worthless depends on the facts and circumstances of each situation, including the value of any collateral securing the debt and the financial condition of the debtor [Reg. §1.166-2(a)]. The taxpayer has the burden of proving that his or her debt is worthless, and failure to do so will result in denial of the bad debt deduction. The taxpayer should be able to show an identifiable event that renders the debt worthless and uncollectible. Legal action is not necessary to prove that the debt is worthless if the surrounding circumstances indicate that the debt is worthless and uncollectible and that legal action to enforce payment would in all probability not be successful [Reg. §1.166-2(b)]. Bankruptcy is generally considered an indication of the worthlessness of at least a part of an unsecured and unpreferred debt [Reg. §1.166-2(c)]. The bad debt deduction is limited to the difference between the claim and the amount received on distribution of the bankrupt debtor’s assets [Reg. §1.166-1(d)(2)].
Objective indicators of worthlessness may include the following:
• A decline in the debtor’s business
• A decline in the value of the debtor’s assets
• The overall business climate
• Serious financial reverses suffered by the debtor
• The debtor’s earning capacity
• Events of default
• Insolvency of the debtor
• The debtor’s refusal to pay
• Actions taken by the creditor to pursue collection
• Subsequent dealings between the creditor and debtor
No single factor is conclusive. The mere fact that a business is in decline, that it has failed to turn a profit or that the debt obligation is difficult to collect is insufficient to prove that the debt has become worthless.
If you have any questions about this topic or other tax related questions, please do not hesitate to contact us at 727-327-1999.
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER, OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
