Thursday, October 17, 2019
When financial and economic conditions sour, one of the issues that can come up concerns the ability to collect on debts. Ag retail businesses are experiencing tougher credit relations with farm clients due to difficult times in some sectors of production agriculture. Thus, a debt can turn into a “bad debt.” That has tax consequences. An income tax deduction is allowed for debts which become worthless within the taxable year.
What does it take to be able to deduct a bad debt? Is there a tax difference between a business bad debt and a non-business bad debt?
Distinguishing between business and non-business bad debts. That’s the topic of today’s blog post.
Elements Necessary For Deductibility
Debtor-creditor relationship. For a bad debt to be deductible, there must be a debtor-creditor relationship involving a legal, valid, and enforceable obligation to pay a fixed or determinable sum of money. See, e.g., Meier v. Comm’r, T.C. Memo. 2003-94; Treas. Reg. §1.166-1(c). In addition, the taxpayer must be able to show that it was the intent of the parties at the time the transaction was entered into to create that debtor-creditor relationship. The requisite intent is established by showing that when the relationship was formed, the taxpayer had an actual expectation of repayment and intended to enforce the debt if necessary. Thus, a deductible bad debt can derive from a loan made in the context of protecting the taxpayer’s investment if the purpose of making the loan was for business and their was intent to collect on the loan if necessary.
While a formal loan agreement helps establish this intent, the lack of one will not absolutely bar the finding of a bona fide debt. Conversely, the existence of paperwork documenting the transaction (such as a note) does not always mean that the transaction constitutes a bona fide debt stemming from a debtor-creditor relationship.
Related party? The fact that the debtor and creditor are related parties does not preclude a bad debt deduction. The key is whether the loan that is now worthless was made for legitimate business purposes and arises from a debtor-creditor relationship and meets the other requirements as noted above. However, the IRS tends to look more closely to debts involving related parties than those involving non-related parties.
Classification of Bad Debts
For individuals and entities taxed as individuals, bad debts may be business bad debts or nonbusiness bad debts. 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.
So what is the distinction between a business bad debt and a nonbusiness bad debt? 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. The loan transaction must have a relationship to the taxpayer’s trade or business. Treas. Reg. §1.166-5(b). According to the U.S. Supreme Court, the relationship of the loan transaction to the taxpayer’s trade or business is dependent upon whether the taxpayer’s “dominant motivation” for the loan was related to the taxpayer’s business. United States v. Generes, 405 U.S. 93 (1972). In Generes, the Court concluded that the taxpayer's status as an employee was a business interest, but the taxpayer’s status as a shareholder was a nonbusiness interest. But, this does not appear to be a blanket rule for every situation. While the Court indicated that a business bad debt can arise from a loan transaction entered into to protect an employment status, source of income, a business relationship or to protect a business reputation, the Court also seemed to indicate that a shareholder can still experience a business bad debt if the loan transaction has a business purpose and otherwise meets the requirements of a business bad debt. The facts are critical.
A taxpayer that is in the trade or business of lending money generally treats uncollectable loans as business bad debts. See, e.g., Henderson, 375 F.2d 36 (5th Cir. 1967); Serot v. Comr., T.C. Memo. 1994-532; aff’d. without pub. op., 74 F.3d 1227 (3d Cir. 1995); Owens v. Comr., T.C. Memo. 2017-157. The cases cited also provide good guidance on how much loan activity is necessary for a taxpayer to be treated as being in the trade or business of lending money.
Claiming the Deduction
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. A business bad debt may be totally worthless (no collection potential) or partially worthless. I.R.C. §166(a)(1)-(2). In any event, the allowed deduction for a bad debt does not include any amount that was deducted in a prior year at a time that the debt was only partially worthless. Treas. Reg. §1.166-3(b).
A bad debt is deductible when worthlessness can be established. A nonbusiness bad debt must be wholly worthless in the year for which the deduction is claimed. Cooper v. Comr., T.C. Memo 2015-191; Treas. Reg. §1.165-5(a)(2). But, the actual tax year of worthlessness can sometimes be difficult to determine. If the IRS, on audit, views worthlessness to have occurred in a year before the bad debt deduction was actually claimed, the applicable statute of limitation for seeking a refund or credit for a bad debt is seven years (rather than the normal three years). I.R.C. §6511(d).
But, a bad debt can’t be claimed if the taxpayer doesn’t have any records or activity to establish that the money transferred created an enforceable loan entered into for profit. That can be 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.
Careful tax planning can help maximize the tax benefit of a bad debt deduction and minimize the economic pain. Today’s post covered the basics of bad debts, perhaps a future post can dig a little further.