The IRS is always skeptical when individual taxpayers claim deductions for bad debt losses. The reason: losses from purported loan transactions are often from some other type of deal that went south. For example, the taxpayer might have actually made a contribution to the capital of a business entity that turned out to be a loser. Or the taxpayer might have advanced cash to a friend or relative — without a written contract — with the unrealistic hope that the money would be paid back.

Therefore, to claim a deductible bad debt loss that will survive IRS scrutiny, you must first be prepared to prove that the loss was actually from a bad loan transaction instead of from some other ill-fated financial move.One Tax Court case illustrates how a taxpayer was unable to accomplish this, and therefore, had to settle for less favorable tax results.Assuming you can establish that you made a legitimate loan that has now gone bad, the next question is whether you have a business bad debt loss or a non-business bad debt loss.This is an important distinction for the following reasons, outlined below:

Bad Debt Tax Facts

1. Non-business bad debts are not deductible and are treated as short-term capital losses.

2. Bona fide business bad debts can be deducted during the taxable year in which they become worthless.

3. Business bad debts must arise from debtor-creditor relationships that are based on valid and enforceable obligations to pay fixed or determinable amounts of money.

4. A gift or contribution to capital is not considered a debt.

Business Bad Debt Losses

Losses from bad debts that arise in the course of the taxpayer’s business (or businesses) are treated as so-called ordinary losses. In general, ordinary losses are fully deductible without any limitations (for an exception, see the “Warning” below). In addition, partial worthlessness deductions can be claimed for business debts that go partially bad under Internal Revenue Code Section 166(b).

Warning: When the taxpayer makes an ill-fated loan to his or her employer that results in a business bad debt loss (because the taxpayer is an employee of the company), the IRS says the write-off should be treated as an unreimbursed employee business expense. That means the write-off is subject to the 2 percent-of-AGI threshold (when combined with certain other miscellaneous itemized deductions such as investment expenses and tax preparation fees). In addition, miscellaneous itemized deductions are completely disallowed under the AMT rules. Unfortunately, the courts have supported the IRS position. (An example is Kenneth Graves, T.C. Memo 2004-140 upheld by the 9th Circuit in 2007.)

Non-Business Bad Debts Losses

Losses from bad debts that do not arise in the course of an individual taxpayer’s business (or businesses) are treated as short-term capital losses. As such, they are subject to the capital loss deduction limitations. Specifically, you can automatically deduct up to $3,000 of capital losses each year even if you have no capital gains ($1,500 if you use married filing separate status). Additional capital losses can only be deducted against capital gains from other sources. So if you have a big non-business bad debt loss and capital gains that amount to little or nothing, it can take many years to fully deduct the bad debt loss. In addition, losses cannot be claimed for partially worthless non-business bad debts.

The Tax Court’s Haury Decision

In a 2012 decision, the Tax Court concluded that an individual taxpayer was only entitled to a non-business bad debt deduction for worthless loans made to two software development companies.

Harry Robert Haury was a software engineer who managed and held substantial stock ownership interests in the two companies, which were attempting to obtain contracts to develop national alert warning software for the Department of Homeland Security. Haury withdrew $434,933 from his IRA and gave the money to the two companies in exchange for interest-bearing promissory notes. The hoped-for government contracts never materialized, and the companies were unable to fully repay the loans, although one company did repay $40,000.

After the taxpayer failed to file a federal income tax return for 2007, the IRS stepped in, and Haury eventually filed a tardy Form 1040 for that year. On the return, he claimed a $413,156 business bad debt deduction. The IRS denied the deduction, and the unhappy taxpayer took his case to the Tax Court where he represented himself.

Unfortunately, the Tax Court opined that the IRS had acted properly in denying the business bad debt deduction. The court felt the taxpayer’s dominant motivation for making the ill-fated loans was not to protect his business of being an employee but to protect his stock investments in the companies. The court gave little weight to the fact that Haury actually received meaningful amounts of salary from one of the companies.

The taxpayer’s “investment in, and management of, the companies do not amount to a trade or business,” the court stated.

Bottom line: The taxpayer was only allowed to claim a non-business bad debt loss. As we explained earlier, non-business bad debt losses are treated as short-term capital losses that can potentially take many years to fully deduct. In this particular case, the taxpayer would need to collect some very hefty post-2007 capital gains to be able to deduct his whopping big non-business bad debt loss anytime soon.

To add insult to injury, the 51-year-old taxpayer also owed the 10 percent early withdrawal penalty on the taxable portion of the money withdrawn from his IRA that was in turn loaned to the two companies. IRA withdrawals before age 59 1/2 are hit with the 10 percent penalty unless an exception applies, and no exception was available in this case. The penalty amounted to more than $30,000. (Harry Haury, TC Memo 2012-215)

Seek professional tax advice anytime you’re about to engage in a significant financial transaction. With advance planning, you may get better tax results. Even if better results are not in the cards, you’ll at least know what you’re getting into tax-wise before you make the deal.


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– content reprinted with permission from BKR International.

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