Discussion:Bad debt categorization
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Discussion Forum Index --> Advanced Tax Questions --> Bad debt categorization
Discussion Forum Index --> Tax Questions --> Bad debt categorization
| 9 January 2009 | |
| TP (a shareholder/employee) had documented loans to Sub S corp at the time of its going out of business. Company had little cash, but sold some assets and took a promissory note in payment, which they later assigned to the TP as repayment against his outstanding loans. The promissory note is properly prepared and recorded so there are no issues on that point
After 3 years the party obligated on the promissory note defaulted and TP filed suit and received a judgement (which is unlikely to ever get collected). Would you categorize this as a business bad debt - the logic being "thats it has a business origin" or once the TP accepted the promissory note it really became a personal bad debt. My leaning is toward business debt, but its a bit of a gray area. | |
| 9 January 2009 | |
| you also have the issue of basis in the note, which may be a lot less than the face amount owed | |
RoyDaleOne (talk|edits) said: | 9 January 2009 |
| Basis issue aside, my comment is that I don't see how you have a business bad debt.
Was the TP in the business of loaning money? I suggest the TP was not the business of loaning money; which is a very difficult tax position to sustain. | |
| 9 January 2009 | |
| I had a client with virtually identical circumstances. On his 2006 return, he reported it, correctly, as a nonbusiness bad debt. But by the time his 2007 return rolled around, he had, according to him, been told by several anomymous advisers and CPAs (some of whom were connected with the original debt which had been defaulted on) that it met the criteria of a business bad debt. I re-researched it and gave him excerpts from the publications and references which I maintained made it clearly a nonbusiness bad debt, plus several tax court cases based on circumstances essentially identical to his. I suggested he seek additional opinions based on the references I had gathered. He came back about 10 days later and said, no doubt about it, nonbusiness bad debt. I think it was the tax court cases that in the end made it unequivocable for him. | |
| 10 January 2009 | |
| IRC 166 says that a business bad debt requires (among other things) that a true creditor-debtor relationship exist and that the debt must have a business purpose.
It does not say that one must be in the business of lending money in order for that relationship to exist. I think its looking for "arms length transactions and properly documented loans". If it can be demonstrated that the loans were used for working capital or asset purchases - the business purpose would certainly be established. I guess the question really becomes "Can a bona fide loan from a shareholder to his corporation, used for a business purpose, EVER be classified a business bad debt or is it always going to be a personal loan and personal bad debt." I can tell you that this type of lending goes on every day within the small business community. I have read some court cases on this matter, but often there were other issues which swayed the court. | |
| 10 January 2009 | |
| If the primary reason for making the loan was to safeguard or insure the client's employment, it is a business bad debt. | |
RoyDaleOne (talk|edits) said: | 10 January 2009 |
| "loans to Sub S corp at the time of its going out of business", this statement of fact makes it very difficult to reach a business bad debt deduction. The lender also must have a business purpose. | |
Harry Boscoe (talk|edits) said: | 10 January 2009 |
"Can a bona fide loan from a shareholder to his corporation, used for a business purpose, EVER be classified a business bad debt or is it always going to be a personal loan and personal bad debt." Yes, it CAN be classified as a business bad debt. And the conditions are hard to meet, natch. It comes down to the lender's motivation at the time the loan was made.
In the Generes case [many years ago, Supreme Court] it was found that to establish an adequate "business purpose" for a shareholder/employee's making the loan, and thus for it to become, later, a business bad debt, the lender's motivation in making the loan to preserve the business, in order to preserve his job, in order to preserve his salary, had to be his predominant motive. Preserving his salary would be a business purpose for the loan, but if it wasn't the *predominant* reason for his making the loan, then the bad debt deduction would be a non-business bad debt deduction. The court acknowledged that there's always a mixed motive for a shareholder/employee to lend money to his business. But it said that even a significant business motive (i.e. to preserve his salary) was not enough to support a business bad debt characterization of the loss. His non-business purpose for making the loan was to protect his investment in the business, and the loss would be treated as a non-business bad debt based on that if the business purpose (keeping his salary) was only a significant motive and not predominant. [Of course, all the other requirements for a valid bad debt had to be there, natch. And incidentally it was completely totally absolutely irrelevant how the business used the money that was lent to it by the shareholder/employee.] | |
| 11 January 2009 | |
| I don’t see a problem with the business bad debt since the original loan was made while the shareholder was gainfully employed (apparently years before the liquidation of the corporation).
The real issue here is whether a default by a third-party (not the borrowing corporation) can generate a business bad debt for the shareholder. The answer is most definitely. See Reg § 1.166-5(b)(1). | |
| 11 January 2009 | |
| Riley's latest post caused me to re-read the original post. The difference between this case and the client I had is that my client was never employed by the S-Corp to which he made the loan. He was simply a creditor. The cases and information cited make it clear this case is distinguishable on that basis. | |
RoyDaleOne (talk|edits) said: | 11 January 2009 |
| I agree relative to the S Corp, that the promissory note for the assets, the nonpayment of which, would be a business bad debt to the S Corp, thus to the shareholder.
However, relative to the loan to the S Corp by the TP I don't think the tax treatment for nonpayment of that loan can be determined. This is because the facts as stated do not give the reason for the loan(s), nor at what time the loans were made from the TP to the S Corp. The fact that the TP took as payment, on the TP's loan to the S Corp, an assignment of a third party's promissory note to the S Corp, does not confer the S Corp's tax attributes relative to the third party's promissory note to the TP. Rather, the TP's tax attributes in the loan to the S Corp attachés to the third party's promissory note. | |
