Arguing the case for a business bad debt deduction.

• Author: Zinneman, David E.

When a shareholder loans money to a corporation, there is a clear expectation that the loan will be repaid. If the loan becomes worthless, deductibility of the loss for tax purposes is based on two criteria: whether (1) a bona fide debt existed, since advances that are not bona fide loans are generally characterized as capital contributions, and (2) the loan is classified as a business or nonbusiness debt. Business bad debts that are completely or partially worthless are deductible as ordinary losses, while nonbusiness bad debts are short-term capital losses only when entirely worthless.(1)

Under Sec. 166(d)(2), a business bad debt occurs either from a debt created or acquired in connection with the taxpayer's trade or business, or from the worthlessness of a debt incurred in the taxpayer's trade or business. The distinction between a business and nonbusiness bad debt is a question of fact and must be determined based on the facts and circumstances. The courts, however, have established minimum criteria that must be met before a business bad debt deduction will be allowed. A general understanding of these criteria can be helpful in establishing the conditions under which the courts may allow a business bad debt deduction. This article will discuss these minimum criteria and provide practical suggestions for shareholders who are contemplating making (or have already made) loans to a corporation, to enhance the likelihood of ordinary loss treatment should the loan become worthless. This article will also discuss the tax consequences when a shareholder guarantees corporate loans.

Debt Versus Capital Contribution

Before considering whether a loan is a business or nonbusiness debt, the shareholder must first establish that the loan is not a contribution to capital. Often, a shareholder of a closely held corporation will advance funds to it without formally documenting that the advance is a loan that is expected to be repaid in the future.(2) This can be a costly mistake if the corporation becomes insolvent and the debt becomes worthless, since only bona fide loans qualify as bad debt losses under Sec. 166.(3)

A bona fide debt "arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money."(4) In assessing whether an advance to a corporation is a loan or a capital contribution, the courts have concluded that the primary factor is the intent of the parties to the transaction.(5) However, this requires a subjective determination of an individual's state of mind at the time the advance was made. In determining the shareholder's intent in advancing funds to a corporation, the courts have identified numerous factors to be considered, including the following:

1. Whether and how the transaction was accounted for on the corporation's books.

2. Whether the taxpayer and the corporation executed a written agreement.

3. Whether the corporation paid or accrued interest on the loan and whether the taxpayer reported interest income from it.

4. Whether repayment was contingent or based on the corporation's earnings.

5. Whether the debt was subordinated to other general creditors and if so, to what extent.

6. The level of capitalization of the corporation.(6)

   Provided the corporation is not deemed "thinly capitalized," a properly documented loan agreement, regular interest payments and proper accounting on the corporation's books should generally preclude a reclassification of a loan as a capital contribution.(7)

   Guarantors' Losses

   When a taxpayer makes payments in satisfaction of an agreement under which the taxpayer acted as a guarantor of a debt obligation, a debtor-creditor relationship arises. A payment in discharge of a taxpayer's obligation under such an agreement is treated as a bad debt when all of the following conditions exist:

1. The agreement was entered into in the course of the taxpayer's trade or business or a transaction for profit;

2. There was an enforceable legal duty on the taxpayer to make the payment; and

3. The agreement was entered into before the obligation became worthless.(8)

   Under the doctrine of subrogation, the taxpayer's debt does not exist until the corporation defaults on the payment and the taxpayer is forced to satisfy his guarantor obligation.(9) Consequently, a deduction for a bad debt is not allowed until the taxpayer's rights against the debtor become worthless. However, if the debt is worthless when acquired (as in the case of a guarantor that acquired subrogation rights as the result of a default on the debt by an insolvent corporation], the regulations allow the taxpayer a bad debt deduction by testing the validity of the debt at the time the guarantee obligation was entered into, rather than at the time the guarantor satisfies the obligation.(10)

   Business Versus Nonbusiness Bad Debt

   Once it has been established that an advance (or a payment made on a guarantee of an obligation) is a bona fide debt, the taxpayer must determine the type of debt it is. Sec. 166(d)(2) defines a nonbusiness debt as a debt other than one created or acquired in connection with the taxpayer's trade or business, or one in which the loss from worthlessness was incurred in the taxpayer's trade or business. Accordingly, two conditions must exist before a worthless debt is classified as a business bad debt: (1) the taxpayer must be engaged in a trade or business; and (2) at the time the debt was acquired, created or became worthless, it must have been related to the taxpayer's trade or business.(11)

   Although a shareholder is generally not considered to be engaged in the same trade or business as that of the corporation, shareholders have been successful in claiming ordinary losses for worthless loans to a corporation by establishing that they made the loan either in their capacity as an employee or in the trade or business of acquiring corporations. (Both of these arguments are discussed later.

   In determining whether the loss from the debt was incurred in the taxpayer's trade or business, a debt that is "proximately related" to the taxpayer's trade or business either when the debt was acquired or created, or at the time of worthlessness, is a...