Employee allowed itemized deduction for worthless loan to employer.

• Author: O'Driscoll, David

P was the sole shareholder and salaried employee of K corporation, managing its daily operations. K had financial difficulties, so P lent K capital in an attempt to continue business operations and pay salaries to its 26 employees. K later filed for bankruptcy. On the final discharge of K's debts, P's loans remained unpaid and worthless because there were insufficient assets in K's estate to satisfy creditors.

P claimed a bad debt deduction for the loans to K on Schedule D, Capital Gains and Losses, and deducted the worthless debt on page 1 of his return on the line denominated "Other gains or (losses)." P now contends that he should have claimed the bad debt as a deduction on Schedule C, Profit or Loss From Business, to arrive at adjusted gross income (AGI). The IRS, on the other hand, allowed the loss as an itemized deduction in arriving at taxable income.

Law

Sec. 166 provides that a business bad debt is deductible as an ordinary deduction for the year in which the debt becomes worthless: "There shall be allowed as a deduction any debt which becomes worthless within the taxable year." Sec. 166(d)(1)(A) states that in the case of a taxpayer other than a corporation, "subsection (a) shall not apply to any nonbusiness debt." Sec. 166(d)(2)(A) and (B) define a nonbusiness debt as a debt other than:

(A) a debt created or acquired ... in connection with a trade or business of the taxpayer; or

(B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.

Thus, subsection (a) allows an ordinary loss deduction only for business bad debts.

Being an employee may be a trade or business for Sec. 166 purposes. For example, an employee may need to lend money to an employer to stay employed. In this case, maintaining his employment was P's dominant...