Deducting business bad debts.

• Author: Ellentuck, Albert B.

It is not uncommon for high-income individual taxpayers to hold uncollectible or worthless business debts. Careful tax planning that maximizes the business bad debt deduction can help minimize the taxpayer's overall economic loss.

Establishing a Bona Fide Debt With a Related Business

A bona fide debt is one arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money (Regs. Sec. 1.166-1(c)).The taxpayer must be able to show that it was the intent of the parties at the time of the transfer to create a debtor-creditor relationship. In other words, the taxpayer must be able to show that at the time of the transaction, he or she had a real expectation of repayment and there was an intent to enforce the indebtedness. A formal loan agreement is not absolutely necessary to create a bona fide debt. Also, the giving of a note or other evidence of legally enforceable indebtedness is not in itself conclusive evidence of a bona fide debt.

The fact that the debtor is a related business does not preclude a bad debt deduction by the individual taxpayer. If owner or related-party loans made for legitimate business purposes become worthless, they are treated no differently than debts to an unrelated party are. Of course, this assumes that the loans meet the bona fide standard (i.e., a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money). Debts between related parties are generally subject to closer scrutiny than other debts.

Distinguishing Business From Nonbusiness Bad Debts

Two types of bad debt deductions are allowed under Sec. 166: business bad debts and nonbusiness bad debts. Business bad debts give rise to ordinary losses, while nonbusiness bad debts give rise to short-term capital losses (Secs. 166(a) and (d)). Because of the limitation on capital losses, distinguishing business and nonbusiness bad debts is critical.

A business bad debt often originates as a result of credit sales to customers for goods sold or services provided. If a sole proprietor sells goods or services on credit and the account receivable subsequently becomes worthless, a business bad debt deduction is permitted, but only if the income arising from the creation of the receivable was previously included in income (Regs. Sec. 1.166-1(e)).Thus, for cash-basis taxpayers, a bad debt deduction is generally not allowed for uncollectible accounts receivable since these items are normally not included in income until received.

Business bad debts can also take the form of loans to suppliers, clients, employees, and distributors. Additionally, a guarantor is allowed a business bad debt deduction for any payment made in the capacity as guarantor if the reason for guaranteeing the debt was business. Here, the guarantor's payment results in a loan to the debtor, and the taxpayer is allowed a bad debt deduction once the loan (including any right of subrogation against the debtor) becomes partially or totally...