Business vs Non-Business Bad Debts-Huge Tax Difference

April 16th, 2023 at 10:41 AM

The current economic climate makes this a good time to focus on bad debt losses.

As an individual taxpayer, deducting bad debt losses has always been controversial with the IRS.

To claim the deduction, you must first establish that the loss was from a bona fide loan transaction that went wrong. So be alert.

• Avoid ill-advised moves, such as making a loan that turns out not to be a loan but a contribution to the capital of a business entity.
• Avoid the informal advance to a friend or relative that becomes an unintended gift.

As an individual taxpayer, you treat non-business bad debt losses as short-term capital losses, which fall under the annual limitation on net capital loss deductions of $3,000 ($1,500 if married, filing separately).

Should you have significant capital loss carryovers from last year’s stock and bond market adding to your loss deductions, you may have to wait until the non-business bad debt loss delivers any tax-saving results.

Establishing the existence of a bona fide debt is crucial in claiming a deductible bad debt loss, and you must use certain factors to prove this. You can use the Sixth Circuit’s 11-factor analysis to show that your loans are bona fide. Here are what we think are the most relevant from the 11 factors:

• Documents with loan descriptions look like loans.
• Loans should show a maturity date and repayment schedule.
• A fixed interest rate indicates a loan.
• Timely fixed-rate interest payments persuasively make the case that shareholder advances are loans.
• Purported loans made by shareholders strictly in proportion to their stock ownership interests indicate equity except when there is only one shareholder.

Remember, you want business bad debt losses. For this to happen, there must be a proximate relationship between your business and the loan for you to claim a business bad debt loss. The Supreme Court stated that to pass the proximate relationship test, you must have a dominant business motivation for making the loan.

In summary, it is essential to understand bad debt loss deductions and how they can impact your taxes.

Mark S. Fine