The tax laws permit you to deduct a debt that becomes worthless. Nonbusiness debts are treated as short-term capital losses, and restrictions apply to their deductibility. The issue of whether a bad debt is deductible requires a thorough examination of the particular facts and circumstances of each case. In order for a non-business bad debt to be deductible, two principal requirements must be satisfied: (1) a bona fide debt must exist, and (2) the debt must become completely worthless in the tax year in which you claim the deduction.
The primary requirement for a bad debt deduction is the existence of a bona fide debt. To satisfy this requirement, you must show that the loan created a valid and legally enforceable obligation of the debtor to pay you a fixed or determinable sum of money. This requires that there be some monetary or other consideration for the loan. Normally, this takes the form of interest payments by the debtor for the use of the funds. If you voluntarily advance money to a person where you have no legal obligation to do so, a valid debt is not created, and you may not claim a deduction if you are not repaid. Nor does a valid debt arise from an advance made with the understanding that the obligation to repay you is conditioned upon the occurrence of an event, such as a loan to be repaid only if the debtor’s business is successful. The failure of your employer to pay you wages to which you are entitled does not create a valid debt if you did not include the disputed amount in income.
It is always prudent to execute written loan agreements specifying the amount of the loan and the terms of repayment. The failure to do so may jeopardize the bad debt deduction if the existence of a bona fide loan is questioned. However, it is also important to recognize that your observance of such formalities is not conclusive. An advance will not be treated as a valid debt if the facts and circumstances indicate that you did not intend to create an enforceable repayment obligation. A bona fide loan does not exist unless you have a good faith intention and expectation that the advance will be repaid. This requirement is particularly significant if you loan money to family members. The IRS is likely to view such advances as gifts, and you have the burden of proof to demonstrate that the advance is a bona fide debt. Similarly, a loan to a business in which you own a substantial interest might be treated as capital contribution rather than bona fide debt if the business is inadequately capitalized and there is substantial risk that the business will not be able to repay the loan. The resolution of these issues requires a careful examination of the facts in each case.
Having established that an advance satisfies the bona fide debt requirement, the second requirement for the deduction is that the debt becomes wholly worthless. The determination of whether a debt is wholly worthless requires a close examination of all the facts and circumstances, particularly the financial condition of the debtor. You must establish that the debt lacks all current and potential value. Even if the debtor cannot currently repay the debt, the possibility of the debtor’s financial revival in the future might preclude the deduction. There are a number of events that are generally recognized as indicating worthlessness, the most significant of which are insolvency and bankruptcy. In some cases, the inability to locate a debtor who has abandoned his obligation on the debt will establish that the debt is worthless. However, these, or other events in themselves, do not necessarily establish that the debt is worthless. It is very important that you make (and document) all reasonable efforts to collect the debt. The failure to do so might prevent you from satisfying your burden of proof that the debt is worthless. However, you are not required to take legal action if the facts and circumstances clearly establish that such action would be futile.
In addition to showing that the debt is worthless, you are entitled to a bad debt deduction only if you demonstrate that the debt became worthless during the tax year in which you claim the deduction. This means that you must show that the debt had some value at the beginning of the year, and has no value at the end of the year. This can be difficult given that worthlessness often is not established by a single event, but by a series of events and circumstances. A common situation is a business debtor that deteriorates to poor financial condition, next to insolvency, and finally to bankruptcy and liquidation. If these events occur over a period of several years, you may have difficulty identifying the precise point at which your debt became worthless. Unfortunately, there is no precise formula. The worthlessness determination is essentially a pragmatic test based on sound business judgment. However, the tax laws contain a special provision that extends the statute of limitation for claiming refunds with respect to bad debts to seven years from the normal three-year period, so that if you choose the “wrong” year you might still be able to claim a refund in the proper year.
As the discussion above demonstrates, your entitlement to a bad debt deduction depends on your ability to show that your advance created a bona fide debt that became wholly worthless in the tax year in which you claim the deduction. This determination can be made only by thoroughly examining the particular facts and circumstances with respect to each loan.
This article outlines only general principles and should not be construed as advice. Contact us to discuss the particular facts of your situation: