Tax Issues With Bad Debt Deductions

Overview

When financial and economic conditions sour, one of the issues that can come up concerns the ability to collect on debts.  Agriculture has been through some difficult times for the past few years, and the occurrence of bad debts has been on the rise.  Ag retail businesses are experiencing tougher credit relations with farm clients.

What does it take to be able to deduct a bad debt?  Is there a difference in the tax of a business bad debt or a non-business bad debt?  What if a parent guarantees the debt of a child?  How do bad debts get reported?  Today’s post examines the basic rules that come into play when dealing with a creditor that doesn’t pay. 

Elements Necessary For Deductibility

Debtor-creditor relationship.  An income tax deduction is allowed for debts which become worthless within the taxable year.  For a bad debt to be deductible, there must be a debtor-creditor relationship involving a legal obligation to pay a fixed sum of money.  See, e.g., Meier v. Comm’r, T.C. Memo. 2003-94.  A bad debt deduction may be claimed only if there is an actual loss of money or the taxpayer has reported the amount as income.  It can’t be claimed if the taxpayer doesn’t have any records or activity to establish that the money transferred created an enforceable loan to her son entered into for profit.  That’s a key point with many farming operations and loans between family members.  See, e.g., Vaughters v. Comr., T.C. Memo. 1988-276.  It’s critical to properly document the arrangement.

A debt may be totally or partially worthless.  A debt is a totally worthless bad debt if the taxpayer is unable to collect what is still owed even though some of the debt had been collected in the past.  The amount remaining to be paid is eligible for a bad debt deduction.  Factors indicating total worthlessness include the debtor being in a serious financial position, insolvency, lack of assets, ill health, or bankruptcy.

Establishing worthlessness.  To be deductible, the debt must be proved to be worthless with reasonable steps taken to collect the debt.  Bankruptcy is generally good evidence that at least part of the debt is worthless, but the debtor’s technical insolvency may not be.  The debtor’s technical insolvency is not enough to conclude that a debt is worthless.  O’Neal Feeder Supply, Inc., v. United States, No. 2:96 CV 0514, 2017 U.S. Dist. LEXIS 1085 (W.D. La. 2000).  But, it is not necessary to resort to legal action if it can be shown that a judgment would not be collectible.

Claiming a Bad Debt Deduction

A deduction may only be claimed in the year a debt becomes worthless – when there is no longer any change it will be paid.  It is not necessary to wait until the debt is due to determine its worthlessness.  But, if a taxpayer recovers a bad debt or part of a bad debt that was allowed as a deduction in a prior year, it is includible in gross income in the year of recovery.  The amount of the deduction is the taxpayer’s adjusted basis in the debt.

Business and Nonbusiness Bad Debts

Bad debts may be business bad debts or nonbusiness bad debts, except that corporations have only business bad debts.  Business bad debts are deducted directly from gross income while a nonbusiness bad debt of a non-corporate taxpayer is reported as a short-term capital loss when it becomes totally worthless.

A business bad debt relates to operating a trade or business and is mainly the result of credit sales to customers or loans to suppliers, clients, employers or distributors.  A bad debt deduction may be taken for accounts and notes receivable only if the amount had been included in gross income for the current or prior taxable year.  While this largely limits bad debt deductions to accrual-basis taxpayers, a business bad debt deduction for a cash basis taxpayer is possible.  For example, a business loan may go sour and the obligation may become worthless.  A business bad debt is one that is incurred in the taxpayer's trade or business.  In money lending situations, the business of the taxpayer must be lending money.

Nonbusiness bad debts are bad debts not acquired or created in the course of operating the taxpayer's a trade or business, or a debt the loss from the worthlessness of which is not incurred in the taxpayer's trade or business.  Thus, a noncorporate taxpayer's bad debts may be either business or nonbusiness bad debts.  To be deductible, nonbusiness bad debts must be totally worthless; partially worthless nonbusiness bad debts are not deductible.  Nonbusiness bad debts are deductible only as short-term capital losses and are reported on Schedule D, Form 1040.  That means that they are not as valuable as business bad debts.

Guarantees

If payment of another's debt is guaranteed, a bad debt deduction may be claimed by the guarantor if payment is made under the guarantee.  To qualify for a deduction, these guarantees must meet one of two conditions - (1) the guarantee must have been entered into for profit with the guarantor receiving something in return; or (2) the guarantee must be related to the taxpayer's trade, business or employment.  In many instances, these requirements can be very difficult to satisfy.  For example, most guarantees are entered into as an accommodation.  In addition, the amount that the guarantor receives in return must be a reasonable amount under the circumstances. 

With respect to the requirement that the guarantee be related to the taxpayer's trade, business or employment, the IRS particularly scrutinizes intra-family arrangements and generally holds that for parents guaranteeing a child's debt, the parent is not in the trade or business of guaranteeing loans.  Instead, the parent typically is in the trade or business of farming or some other enterprise.  In one Tax Court case, for example, the court held that a father's guarantee of his sons' bad debts was not a business bad debt.  The father was receiving rent from his sons, and argued that the rental amounts represented a receipt of consideration.  The father also argued that the guarantee was given in the ordinary course of business.  The Tax Court disagreed on both counts.  See, e.g., Lair v. Comr., 95 T.C. 484 (1990). 

The loss associated with a guarantee may be either from a business or be a nonbusiness bad debt depending upon the facts of the situation.  To qualify as a business bad debt, the taxpayer must show that the reason for guaranteeing the debt was closely related to the taxpayer's trade or business.  If the reason for making the guarantee was to protect the taxpayer's investment but not as part of the taxpayer's trade or business, a guarantee may give rise to a nonbusiness bad debt.  Guarantees made as a favor to friends where the taxpayer received nothing in return do not give rise to a deduction.

Related Issues With Guarantees

Because a guarantor is only secondarily liable and becomes liable only on the principal's default and notice, a release of the guarantor before becoming primarily liable does not appear to involve discharge of indebtedness income.  In the event a guarantor has become primarily liable, release of the guarantor would seem to produce the possibility of discharge of indebtedness income.

Likewise, a deduction may be available for interest paid by a guarantor after the primary obligor is discharged in bankruptcy.

Reporting Bad Debts

A bad debt deduction must be explained on the income tax return with a statement attached that shows a description of the debt, the name of the debtor, the business or family relationship between the creditor and debtor, if any, the date the debt became due, efforts made to collect the debt and basis upon which the decision was made that the debt was worthless.  For business bad debts, the amount claimed as a deduction should be reported on Form 1120 or 1120-S in the case of a corporation.  

The amount of deduction attributable to a business bad debt should be reported on Form 1065 for partnerships and Form 1040 for bad debts incurred in relation to a trade or business as an employee.  The amount claimed as a deduction for a business bad debt for individuals carrying on the business of farming as a sole proprietor are reported on Schedule F of Form 1040.  For individuals carrying on a trade or business other than farming as a sole proprietor, business bad debts are reported on Schedule C of Form 1040.

Nonbusiness bad debts for individuals are deducted on Form 8949 as a short-term capital loss.  with various notations.  A separate line should be used for each bad debt.  In addition, a nonbusiness bad debt, to generate a deduction, requires a separate detailed statement attached to the return. 

Nonbusiness bad debts for partnerships are entered on Schedule D, Form 1065 in the same manner as above shown for Schedule D, 1040, for individuals.

Conclusion

Tough times create financial issues, and associated tax issues.  But, if the rules are followed, the tax Code can help soften the blow of uncollectable debts by allowing a deduction.