There is a level of skepticism at the IRS when individual taxpayers claim deductions for bad debts. To claim a bad debt loss that will survive IRS scrutiny, you must be prepared to prove that the loss was actually from a bad loan transaction instead of some other ill-fated financial move.

There must be a valid and legally enforceable obligation to pay you a fixed or determinable sum of money. This means having a formal written agreement.

Assuming you can establish that you made a legitimate loan that has now gone bad, the next question is whether you have a business bad debt loss or a non-business bad debt loss. This is an important distinction.

Business Bad Debt Losses

Losses from bad debts that arise in the course of the taxpayer’s business are treated as ordinary losses. In general, ordinary losses are fully deductible without any limitations (for an exception, see the “Warning” below). In addition, deductions can be claimed for business debts that go partially bad under Internal Revenue Code Section 166(b).

Note:
If a taxpayer makes a loan to his or her employer to help protect their job, this would be classified as a business bad debt if the employer defaults. The IRS says this write-off should be treated as an unreimbursed employee business expense. That means the write-off is subject to the 2 percent-of-AGI threshold (when combined with certain other miscellaneous itemized deductions such as investment expenses and tax preparation fees). In addition, miscellaneous itemized deductions are completely disallowed under the AMT rules. Unfortunately, the courts have supported the IRS position.

Non-Business Bad Debts Losses

Losses from bad debts that do not arise in the course of an individual taxpayer’s business are treated as short-term capital losses. As such, they are subject to the capital loss deduction limitations. Specifically, you can deduct a maximum of $3,000 net capital loss each year ($1,500 for married filing separate status), after your capital losses are netted with capital gain income. The balance of the loss would be carried over to future years. So if you have a big non-business bad debt loss and capital gains that amount to little or nothing, it can take many years to fully deduct the bad debt loss. In addition, losses cannot be claimed for partially worthless non-business bad debts.

Tax Court News

In a 2012 decision, the Tax Court concluded that an individual taxpayer was only entitled to a non-business bad debt deduction for worthless loans made to two software development companies.

Harry Robert Haury was a software engineer who managed and held substantial stock ownership interests in the two companies, which were attempting to obtain contracts to develop national alert warning software for the Department of Homeland Security. Haury withdrew $434,933 from his IRA and gave the money to the two companies in exchange for interest-bearing promissory notes. The hoped-for government contracts never materialized, and the companies were unable to fully repay the loans, although one company did repay $40,000.

After the taxpayer failed to file a federal income tax return for 2007, the IRS stepped in, and Haury eventually filed a tardy Form 1040 for that year. On the return, he claimed a $413,156 business bad debt deduction. The IRS denied the deduction, and the unhappy taxpayer took his case to the Tax Court where he represented himself.

Unfortunately, the Tax Court opined that the IRS had acted properly in denying the business bad debt deduction. The court felt the taxpayer’s dominant motivation for making the ill-fated loans was not to protect his business of being an employee but to protect his stock investments in the companies. The court gave little weight to the fact that Haury actually received meaningful amounts of salary from one of the companies.

The taxpayer’s “investment in, and management of, the companies do not amount to a trade or business,” the court stated.

Lessons Learned:

The taxpayer was only allowed to claim a non-business bad debt loss. As we explained earlier, non-business bad debt losses are treated as short-term capital losses that can potentially take many years to fully deduct. In this particular case, the taxpayer would need to collect some very hefty post-2007 capital gains to be able to deduct his whopping big non-business bad debt loss anytime soon.

To add insult to injury, the 51-year-old taxpayer also owed the 10 percent early withdrawal penalty on the taxable portion of the money withdrawn from his IRA that was in turn loaned to the two companies. IRA withdrawals before age 59 1/2 are hit with the 10 percent penalty unless an exception applies, and no exception was available in this case. The penalty amounted to more than $30,000. (Harry Haury, TC Memo 2012-215)

Seek professional tax advice anytime you’re about to engage in a significant financial transaction. With advance planning, you may get better tax results. Even if better results are not in the cards, you’ll at least know what you’re getting into tax-wise before you make the deal.