Sec. 166(d) provides that noncorporate taxpayers can claim short-term capital losses for nonbusiness bad debts. Nonbusiness bad debts are those debts that do not qualify as business debts (i.e., not created or acquired in the ordinary course of a taxpayer’s business or incurred in the taxpayer’s business). For a taxpayer to claim a nonbusiness bad debt deduction, the debt must be totally worthless; a partially worthless debt cannot be deducted. Also, the deduction can be claimed only in the year of worthlessness.
Planning tip: Taxpayers should claim a nonbusiness bad debt deduction in the earliest year possible, based on the facts. Then, if the IRS subsequently finds that worthlessness actually occurred in a later year, the statute of limitation for the later year should still be open. The taxpayer could then amend the return for the year worthlessness actually occurred to claim the bad debt deduction (assuming the IRS disallowed the deduction for the earlier year).
It is not unusual for taxpayers to lend money to other family members or guarantee their debts. Although Sec. 166 does not prohibit taxpayers from claiming bad debt deductions in these situations, they are generally subject to close scrutiny (Caligiuri, 549 F.2d 1155 (8th Cir. 1977)). Transfers between family members are generally presumed to be gifts unless the taxpayers prove that a bona fide debt exists (Perry, 92 T.C. 470 (1989), aff ’d, 912 F.2d 1466 (5th Cir. 1990); Vinikoor, T.C. Memo. 1998-152).
Intrafamily loans
If a bona fide loan exists between family members, the lender can claim a bad debt deduction if the borrower defaults and the lender makes a demand for payment. To qualify as a loan, an advance must be made with a reasonable expectation that it will be repaid and that payment is not contingent on the occurrence of some future event (Zimmerman, 318 F.2d 611 (9th Cir. 1963)).
Taxpayers making intrafamily loans can better their chances of later claiming a bad debt deduction if they follow certain loan formalities when the loan is made. The more the loan attributes equate with standard commercial terms, including the borrower’s responsibility for the reasonable costs of collection (e.g., attorney fees), the more likely the bad debt deduction will be allowed. Although no one factor is controlling, the courts have generally looked at the intent of the parties and the existence of the following as evidence that a bona fide debt exists:
Advances made after a family member becomes insolvent are deemed to be gifts since a reasonable expectation of repayment could not exist when the advance is made (Hunt, T.C. Memo. 1989-335). Also, where a familycontrolled corporation made loans to the son of the company’s founder, even though the loans were evidenced by promissory notes with fixed maturity dates, factors the Tax Court held indicated the loans were not bona fide debt included that the company did not enforce repayment and that it continued advancing funds after the son failed to repay previous amounts due (VHC, Inc., T.C. Memo. 2017-220, aff ’d, 968 F.3d 839 (7th Cir. 2020)).
Legal action is not required to show that an effort was made to collect on the note. If the circumstances indicate that legal action would in all probability not result in the ultimate collection of the debt from the borrower, a showing of these facts is sufficient evidence of worthlessness (Regs. Sec. 1.166-2(b)).
Note: Although loan formalities such as those described here can help establish the existence of a bona fide debt, a debtor-creditor relationship can still exist without them. Even in family situations, if the parties’ actions show that there was an actual intent to repay the loan and that the failure to do so was due to the eventual distressed financial condition of the borrower, a nonbusiness bad debt can be claimed (Bowman, T.C. Memo. 1995-259). And, even if the formality of a note or other legal evidence of a debt exists, that, in itself, is not conclusive that a bona fide debt exists. The intent of the parties to actually create a debtor-creditor relationship must be present (Rodgers, T.C. Memo. 1985-220). Nevertheless, the better the loan documentation, the better the chances of establishing the existence of a bona fide debt.
Intrafamily loan guaranties
If a taxpayer is called upon to make a payment on a loan he or she has guaranteed, certain requirements must be met before the taxpayer can claim a bad debt deduction for the payment. To claim a deduction, the taxpayer must show that the guaranty was made in the course of his or her trade or business or in a transaction entered into for profit (Regs. Sec. 1.166-9(d)). In addition, the taxpayer must receive reasonable consideration for entering into the loan guaranty.
For the guaranty of a non–family member’s debt, the consideration can be either direct (i.e., cash or other property) or indirect. Indirect consideration is determined in accordance with normal business practice and may, for example, be in the form of improved business relationships. For the guaranty of a family member’s debt, however, the consideration must be direct, in the form of cash or other property (Regs. Sec. 1.166-9(e)(1)). For this purpose, “family member” is defined very broadly (e.g., it includes in-laws and step relationships) and includes all individuals listed in Sec. 152(a).
Individuals often guarantee loans of relatives as a personal favor and without direct consideration (i.e., cash or other property). This failure to receive direct consideration in exchange for entering into the guaranty agreement will prevent a taxpayer from claiming a bad debt deduction if he or she ultimately makes payment on the guaranty, even though the taxpayer may improve his or her relationship with the lender (Clanton, T.C. Memo. 1995-416).
When payment is made under a loan guaranty, the taxpayer usually assumes the role of the original lender. Thus, payment under the guaranty generally gives the guarantor the right to, in turn, demand payment from the borrower. If this is the case, the guarantor taxpayer cannot claim a bad debt loss until reasonable collection efforts against the borrower have failed. Often, this means a bad debt loss will not be allowable in the same year payment under the guaranty occurs (Regs. Sec. 1.166-9(e) (2)). Once collection efforts have failed, the guarantor taxpayer has either a business or nonbusiness bad debt loss (or a gift), depending on the facts and circumstances of the taxpayer’s original guaranty transaction.
Example. Structuring an intrafamily advance to avoid gift treatment: F Jr. wants to start his own business. He estimates that he needs $25,000 of initial capital. The local bank will lend him this amount only if he can get the guaranty of his father, F Sr. Alternatively, he may be able to get the funds directly from his father.
F Sr. believes his son’s business has a reasonable chance of success and agrees to assist him. However, he would like to avoid an outright gift so that F Jr. takes the business endeavor seriously. He would also like to claim a loss deduction in the event that F Jr.’s business fails and he is ultimately out $25,000.
If F Sr. advances the funds directly to his son, he should ensure the advance is structured as a bona fide loan, evidenced by a signed promissory note with a fixed repayment schedule and a reasonable interest charge. If, instead, he guarantees a bank loan for his son, he must make sure he receives direct consideration (i.e., cash or other property) from his son in exchange for entering into the guaranty agreement. The regulations give no guidance as to how much constitutes a reasonable amount of consideration. Again, direct consideration is required to be eligible to claim a bad debt on an intrafamily loan guaranty and could, for example, be in the form of a cash fee or an ownership interest (e.g., stock) in the business. Either of these arrangements should enable F Sr. to claim a nonbusiness bad debt deduction in the event he ultimately pays and is unable to collect repayment on the $25,000 advance to or for the benefit of his son.
Note: If F Jr. ultimately defaults on the note and is unable to repay his father, he will likely have cancellationof- debt (COD) income (Sec. 61(a)(11)). However, to the extent he can show that he is insolvent when discharged, he may be able to avoid tax on the COD income (Sec. 108(a)(1)(B)).
This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Individual Tax Planning topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).
Contributor
Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.