Case — Bad Debt – Business or Non-Business?

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TL Case Summ

THE QUESTION

When a loan made to a business by a stockholder/employee goes bad, can the stockholder/employee claim a business bad debt?

THE DISPUTE

Taxpayer Says: Money transferred to the company from his Individual Retirement Accounts were bona fide debts and eligible for deduction as business bad debts.

Internal Revenue Service Says: The loans were made to protect the taxpayer’s investment interests in the companies rather than protection of his salary, and they are non-business bad debts.

THE LAW

From Internal Revenue Code Section 166(d)(1)(B): Non-business bad debts are not deductible and are treated as short-term capital losses.

From Internal Revenue Code Section 166(a)(1), (d)(1): Bona fide business bad debts may be deducted during the taxable year in which they become worthless.

From Internal Revenue Code Section 166(d)(2): Defines a “non-business debt” by exclusion; i.e., it is “a debt other than–(A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer, or (B) a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.”

From Federal Tax Regulation 1.166-1(c): Business debts must arise from debtor-creditor relationships that are based upon valid and enforceable obligations to pay fixed or determinable amounts of money.

THE CAUSE OF THE DISPUTE

When you suffer a loss from a bad debt, the type of loss is generally determined based on your motivation for making the loan. For instance, if you’re an employee and you make a loan to protect your employment, any resulting loss of your loan may be considered an employee business bad debt.

When your dominant motive for making a loan is to protect your investment in a company, the loss is a non-business bad debt. That’s because investing your money and managing your investments is not considered a trade or business, no matter the extent of your investments, or whether you invest in a publicly- or privately-held company.

When you’re an employee/stockholder and you earn compensation attributable to your services in addition to your investment return, you may be more than a passive investor, and your activities may rise to the level of a trade or business. When the compensation is your main source of income, as long as your primary purpose for making the loan is to protect or enhance your employment, any resulting loss may be a business bad debt.

Disputes arise because of the tax treatment of various types of losses from bad debts. Employee business bad debts are deductible as an employee business expense, which is a miscellaneous itemized deduction. Non-business bad debts are deductible as short-term capital losses, and the amount you can deduct is limited by the capital loss rules. Business bad debts are deductible in the year the debt becomes worthless, and are an ordinary loss, not subject to capital loss limitations.

In this case, the taxpayer, a software engineer, owned interests of 49.2% and 48.3% in two companies that together had paid-in capital of approximately $9.2 million. He was not the sole owner nor the sole employee of either company, and he took a salary from one of the companies in 2005, 2006, and 2007 ($147,612 for 2005 and 2006, and $149,216 in 2007).

In 2007, the companies began developing software for the Department of Homeland Security. To cover the software development costs, the taxpayer loaned the companies $434,933 from his Individual Retirement Account. Part of the loan ($120,000) was repaid in 2007, and the remainder was documented by valid enforceable interest-bearing notes, and was reported on the company’s federal income tax return for the year ended October 31, 2007 as long-term notes payable.

In December 2007, the Department of Homeland Security declined to authorize a contract for the software, and the companies were unable to repay the debt to the taxpayer. The notes were not reported on the December 2007 financial statements. After 2007, the taxpayer collected no salary from either company, and the companies made no repayments to him on the loans, though an outside investor was repaid $40,000 on a separate loan made during the same time.

The taxpayer claimed a business bad debt of $413,156 on his personal tax return for 2007.

The IRS says the loans were made primarily to protect the taxpayer’s investment in the success of the companies rather than to protect his salary, and that they were non-business bad debts, subject to the capital loss limitation rules.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 16KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The taxpayer’s investment in and management of the companies do not amount to a trade or business. Moreover, the dominant motivation for making the loans was not taxpayer’s trade or business as an employee of the companies. The taxpayer designed the software used by the companies and invested a significant amount of time and money to ensure the success of the companies. Protection of investment interests in the companies, rather than protection of salary, was the dominant motivation for the loans. We note that the taxpayer worked for the companies without compensation after 2007. Accordingly, the taxpayer’s loans to the companies were non-business debt.
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