It is virtually inevitable that we may, at one time or another, incur a financial loss in our business or personal life. Whether made in the course of business, or to a friend or relative, sometimes a loan simply cannot be repaid despite the best intentions of the debtor. If there is little or no prospect that repayment can be made in the future, you may have a bad debt. From a tax standpoint, the question is how to handle the bad debt. What steps should you take to derive the maximum tax benefits available from this loss?
The first step is to determine that a real debt exists. There must be a valid and legally enforceable obligation to pay you a fixed or determinable sum of money. Loans between family members or other related parties, such as corporations and their shareholders, are particularly scrutinized to make sure that they are really debts rather than disguised gifts, dividends, or contributions to the corporation’s capital. Therefore, if you are contemplating a loan to a related party, you must ensure that you treat the transaction as a true loan by taking the steps that a professional lender would take, such as putting it in writing and charging a reasonable rate of interest.
It then must be determined if, and when, the debt has become totally or partially worthless, i.e., a bad debt. The problem is the IRS often requires taxpayers to play a guessing game. If a taxpayer claims a bad debt loss when nonpayment is only probable, rather than a virtual certainty, the IRS may disallow the loss as premature because there is some possibility of repayment in a later year. Otherwise, if the taxpayer waits until repayment is clearly hopeless, the IRS may maintain that the debt was really worthless in an earlier year, and the loss should have been taken at that time. As you can incur potential statute of limitations problems, we generally recommend that the loss be claimed in the earliest possible year that it can reasonably be argued to be worthless.
Once it is established that a bad debt exists, the business or nonbusiness nature of the debt decides the outcome. A business bad debt must be created, acquired, or become worthless in the course of a trade or business. If you conduct a business in the form of a corporation, generally, any debt held by the corporation is a business debt. Any debt not falling into the business category is a nonbusiness debt. A nonbusiness debt must be completely worthless before a loss can be taken, whereas a loss on a business bad debt can be taken when partial worthlessness can be established. All nonbusiness bad debts are subject to the limitations on capital losses. Business bad debts are deductible as ordinary losses in full against your other income.
This is a complex topic. If you are, or may be in a situation where these rules could affect you, please contact Henssler Financial at 770-429-9166 or [email protected].