Structuring intrafamily advances to permit bad debt deductions.

• Author: Ellentuck, Albert B.

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

It is not unusual for taxpayers to loan money to other family members or guarantee their debts. Although Sec. 166 does not bar taxpayers from claiming bad debt deductions in these situations, they are generally subject to close scrutiny; see Caligiuri, 549 F2d 1155 (8th Cir. 1977). Transfers between family members are generally presumed to be gifts, unless the taxpayers prove that a bona fide debt exists; see Perry, 92 TC 470 (1990), aff'd, 912 F2d 1466 (5th Cir. 1990), cert. den., and Vinikoor, TC 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 demands 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; see Zimmerman, 318 F2d 611 (9th Cir. 1963).

Taxpayers making intrafamily loans can better their chances of later claiming a bad debt deduction if they follow certain 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 (attorneys' fees)), the more likely the bad debt deduction will be allowed. Although no one factor is controlling, the courts have generally looked at the parties' intent and the existence of the following as evidence that a bona fide debt exists: (1) a note or other evidence of indebtedness; (2) interest being charged; (3) a fixed repayment schedule; (4) security or collateral; (5) a demand for repayment; (6) the parties' records, if any, reflecting the transaction as a loan; (7) any repayments made; and (8) the solvency of the borrower. Advances made after a family member becomes insolvent are deemed to be gifts, because a reasonable expectation of repayment could not exist when the advance is made; see Hunt, TC Memo 1989-335.

Legal action is not required to show that an effort was made to collect on the note. According to Regs...