Bad debt deductions from intrafamily advances.

• Author: Young, Patrick L.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Individual Tax Planning topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).

Sec. 166(d) provides that noncorporate taxpayers can claim short-term capital losses for nonbusiness bad debts. Nonbusiness bad debts are those debts that do not qualify as business debts (i.e., not created or acquired in the ordinary course of a taxpayer's business or incurred in the taxpayer's business). For a taxpayer to claim a nonbusiness bad debt deduction, the debt must be totally worthless; a partially worthless debt cannot be deducted. Also, the deduction can be claimed only in the year of worthlessness.

Planning tip: Taxpayers should claim a nonbusiness bad debt deduction in the earliest year possible, based on the facts. Then, if the IRS subsequently finds that worthlessness actually occurred in a later year, the statute of limitation for the later year should still be open. The taxpayer could then amend the return for the year worthlessness actually occurred to claim the bad debt deduction (assuming the IRS disallowed the deduction for the earlier year).

It is not unusual for taxpayers to lend money to other family members or guarantee their debts. Although Sec. 166 does not prohibit taxpayers from claiming bad debt deductions in these situations, they are generally subject to close scrutiny (Caligiuri, 549 F.2d 1155 (8th Cir. 1977)). Transfers between family members are generally presumed to be gifts unless the taxpayers prove that a bona fide debt exists (Perry, 92 T.C. 470 (1989), aff'd, 912 F.2d 1466 (5th Cir. 1990); Vinikoor, T.C. Memo. 1998-152).

Intrafamily loans

If a bona fide loan exists between family members, the lender can claim a bad debt deduction if the borrower defaults and the lender makes a demand for payment. To qualify as a loan, an advance must be made with a reasonable expectation that it will be repaid and that payment is not contingent on the occurrence of some future event (Zimmerman, 318 F.2d 611 (9th Cir. 1963)).

Taxpayers making intrafamily loans can better their chances of later claiming a bad debt deduction if they follow certain loan formalities when the loan is made. The more the loan attributes equate with standard commercial terms, including the borrower's responsibility for the reasonable costs of collection (e.g., attorney fees), the more likely the bad debt deduction will be allowed...