Arguing the case for a business bad debt deduction.

When a shareholder loans money to a corporation, there is a clear expectation that the loan will be repaid. If the loan becomes worthless, deductibility of the loss for tax purposes is based on two criteria: whether (1) a bona fide debt existed, since advances that are not bona fide loans are

generally characterized as capital contributions, and (2) the loan is classified as a business or nonbusiness debt. Business bad debts that are completely or partially worthless are deductible as ordinary losses, while nonbusiness bad debts are short-term capital losses only when entirely worthless.(1)

Under Sec. 166(d)(2), a business bad debt occurs either from a debt created or acquired in connection with the taxpayer's trade or business, or from the worthlessness of a debt incurred in the taxpayer's trade or business. The distinction between a business and nonbusiness bad debt is a question of fact and must be determined based on the facts and circumstances. The courts, however, have established minimum criteria that must be met before a business bad debt deduction will be allowed. A general understanding of these criteria can be helpful in establishing the conditions under which the courts may allow a business bad debt deduction. This article will discuss these minimum criteria and provide practical suggestions for shareholders who are contemplating making (or have already made) loans to a corporation, to enhance the likelihood of ordinary loss treatment should the loan become worthless. This article will also discuss the tax consequences when a shareholder guarantees corporate loans.

Debt Versus Capital Contribution

Before considering whether a loan is a business or nonbusiness debt, the shareholder must first establish that the loan is not a contribution to capital. Often, a shareholder of a closely held corporation will advance funds to it without formally documenting that the advance is a loan that is expected to be repaid in the future.(2) This can be a costly mistake if the corporation becomes insolvent and the debt becomes worthless, since only bona fide loans qualify as bad debt losses under Sec. 166.(3)

A bona fide debt "arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money."(4) In assessing whether an advance to a corporation is a loan or a capital contribution, the courts have concluded that the primary factor is the intent of the parties to the transaction.(5) However, this requires a subjective determination of an individual's state of mind at the time the advance was made. In determining the shareholder's intent in advancing funds to a corporation, the courts have identified numerous factors to be considered, including the following: