Tax Deductions for Bad Debt and Worthless Securities

When can a taxpayer deduct losses sustained as a result of a bad debt? What is the difference between a business bad debt and a nonbusiness bad debt?

A bad debt is a specific obligation which can be deemed with reasonable certainty to have become totally or partially worthless. If this is the case, the creditor-taxpayer may be entitled to a deduction corresponding to the amount of the worthless debt.

There are two kinds of bad debt deductions: (1) business bad debts and (2) nonbusiness bad debts. A business bad debt, as the name suggests, is a debt that is incurred in the conduct of the taxpayer’s trade or business. A nonbusiness bad debt is defined, by exclusion, in IRC Section 166(d)(2) as a bad debt other than a debt (a) created in the conduct of the taxpayer’s business or (b) the loss from the worthlessness of which was incurred in the conduct of the taxpayer’s trade or business. The second exclusionary rule allows a taxpayer who was not the original creditor to claim a worthless debt acquired in the conduct of business.

The classification as either a business or nonbusiness bad debt is important because only a business bad debt can be treated as a deduction from ordinary income, while nonbusiness bad debts receive a capital loss treatment. Further, a taxpayer can claim a deduction for wholly or partially worthless business bad debts, while nonbusiness bad debts must be completely worthless for the deduction to be allowed.

Whether a debt is incurred in relation to a taxpayer’s trade or business, so as to be classified as a business bad debt, is a question of fact. In making the determination, it is important to note that a taxpayer is not restricted to one type of business and that there is no requirement that the loss be incurred in conducting the business in which the taxpayer spends the majority of taxpayer’s time.

A deduction for a loss sustained as the result of a bad debt will only be permitted in cases where both a valid debt and a true debtor-creditor relationship exist.  Whether a valid debt or a true debtor-creditor relationship exists is also a question of fact. A bad debt deduction will not be allowed in a situation where the debt is secured by collateral and the creditor has foreclosed on the collateral due to nonpayment.

Bad debts of corporations, except for S corporations, are always classified as business bad debts. An S corporation is required to separately state its nonbusiness bad debt, which is taxed under the rules applicable to short-term capital losses.

A discharge of one’s obligation as a guarantor is considered a nonbusiness bad debt. The loss sustained by a guarantor unable to recover from the debtor is by its very nature a loss from a bad debt to which the guarantor becomes subrogated upon discharging his liability as guarantor.

If the debt fails to qualify as a business bad debt, it can, in many cases, be treated as a nonbusiness bad debt. If the taxpayer fails to establish that a debt qualifies as a business bad debt the taxpayer must be satisfied with treatment as a nonbusiness bad debt under that same section and may not look for an alternative means of treating loss on the debt as an ordinary loss deduction.

When is a deduction permitted if a taxpayer owns securities that become worthless?

IRC Section 165 allows a deduction for losses incurred based on ownership of securities that have become completely worthless during the year. The term “security” for purposes of IRC Section 165 includes shares of stock, stock rights or evidence of indebtedness issued by a corporation or a government. The worthlessness of the security is a question of fact and the loss will be disallowed unless the taxpayer is able to furnish proof of the original cost of the security.

There are no fixed rules that apply when determining whether a security is completely worthless. The taxpayer is required to make a reasonable inquiry, and what is reasonable here is based on the inquiry that a reasonable person would make in order to determine the worthlessness of the securities. Worthlessness must be determined objectively.

The securities do not have to be sold to establish worthlessness, but it is insufficient to show that the securities would have no value if sold. Diminution in value is also not enough to establish worthlessness.

Worthless securities also include securities that the taxpayer abandons after March 12, 2008. To abandon a security, all rights in the security must be permanently surrendered and relinquished and no consideration received in exchange for the security. All the facts and circumstances determine whether the transaction is properly characterized as an abandonment or other type of transaction, such as an actual sale or exchange, contribution to capital, dividend, or gift.

Instead, the worthlessness of securities is generally established by a showing that an identifiable event (or series of events) occurred, and that it is reasonably certain the event (or events) rendered the securities completely worthless. An identifiable event has been judicially defined as an incident or occurrence that points to or indicates a loss-an evidence of a loss. The identifiable event may be an actual cancellation of the debt or it may be an event the applicable entity is required, solely for purposes of reporting to the IRS, to treat as a cancellation of debt.

Is a bad debt deduction permitted when a loan made between related parties becomes worthless?

A bad debt deduction may still be allowed in situations where the bad debt results from a loan made between related parties. The analysis of whether a worthless loan made between related parties gives rise to an allowable bad debt deduction is not the same as the analysis undertaken under IRC Section 267, however, which disallows certain losses on sales between related parties.

Intrafamily transactions are subject to rigid scrutiny, however,  and transfers between two spouses are presumed to be gifts. However, this presumption may be rebutted by an affirmative showing that there existed at the time of the transaction a real expectation of repayment and intent to enforce the collection of the indebtedness.

The relevant inquiry in the bad debt context is whether the transaction was a valid loan or was instead a gift made between related parties. In making the determination, the courts examine all of the relevant facts and circumstances of the specific case.

In connection with this facts and circumstances inquiry, it is important that both parties must intend and agree to treat the transaction as a loan, rather than as a disguised gift. Proper documentation of the transaction, while not strictly required, is helpful in proving the parties’ intentions. Regardless of whether the loan would have been extended had the parties not been related, the deduction should be sustained if, at the time the loan is made, there is a true intention amongst the parties that the debt will eventually be repaid.

--- Related on ThinkAdvisor: 23 Days of Tax Planning Advice: 2017

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