Taxpayer allowed a bad debt deduction for certain personal loans
INSIGHT ARTICLE |
In a recent case, see William C. Owens, et ux. v. Commissioner, the Tax Court concluded that, during the years at issue, the taxpayer was engaged in the trade or business of lending money and his personal loans constituted bona fide debt that had become worthless during the years at issue. Accordingly, the court held that the taxpayer was entitled to the bad debt deduction he had claimed for the worthless debt.
In this case the taxpayer, Owens, made several significant personal loans – to the tune of approximately $16 million – to a commercial laundry business over the course of several years. After the severe financial decline of the laundry business, which filed for chapter 7 bankruptcy, Owens was left unable to recover any of the personal loans he had made to the enterprise. The issue in the case was threefold, whether the taxpayer was engaged in the trade or business of lending money, whether the personal loans constituted bona fide debt, and whether the loans had become worthless during the years at issue.
A noncorporate taxpayer may have two types of bad debt, business or nonbusiness – each with very different consequences to the taxpayer. Nonbusiness bad debts will generally result in a short-term capital loss to the taxpayer for the year in which the debt becomes worthless. Business bad debts, on the other hand, will generally have a much more favorable treatment. Specifically, a taxpayer will generally be entitled to an ordinary deduction for the amount of any bona fide business bad debt that becomes worthless during the tax year.
In order for a bad debt to be a “business” bad debt – thus entitling the taxpayer to an ordinary deduction for amounts that become worthless during the year – the debt must be acquired or created in connection with the taxpayer’s trade or business, be bona fide debt, and become worthless during the year the deduction is claimed. This generally requires an assessment of all the facts and circumstances in order to make a determination. The Court methodically examined the facts surrounding the loans to make this assessment.
First, the court looked to whether Owens’ personal money lending activity rose to the level of a trade or business for the years at issue. Specifically, the court noted that in order for the personal lending activity to be considered a trade or business activity, Owens must have engaged in the activity “with continuity and regularity – with the primary purpose of earning income or making a profit.” In this case, the court found, among other things, that Owens had made just over 30 personal loans, totaling in excess of $20 million, to various borrowers during the years at issue, and did so with the primary purpose of generating a profit. Accordingly, the court determined that Owens was in the trade or business of lending money for the years in at issue. The court next turned to the question of whether the purported loans were bona fide debt.
In making their determination, the court looked to several factors (11 to be exact) to assess whether the personal loans represented bona fide debt. Most notably, the court found that the loans were evidenced by promissory notes between Owens and the borrower, the promissory notes had a specified maturity date, Owens had a right to enforce payment of the promissory notes, and both parties intended the promissory notes to be loans – as opposed to an equity investment in the laundry business. Accordingly, the court determined that the loans represented bona fide debt.
Finally, the court looked to whether the loans became worthless during the tax year in which the deduction was claimed. This determination, as with the others, required a facts and circumstances analysis of the relevant evidence. In this case, the court looked to the fact that during the year Owens claimed the debt to be worthless, the laundry business had filed for bankruptcy, was going to lose its primary customer, had lost its reputation in the business community, and had little means by which to resurrect the business. In addition, the remaining collateral of the business was insufficient to cover the loans Owens had made, and any collateral that was available was required to be distributed to other lenders before Owens. Based on this, the court found that the loans had, in fact, become worthless in the year Owens had claimed the deduction.
While the facts in this case were largely in the taxpayer’s favor, it’s important to remember that the determination of whether a bad debt is a “business” bad debt requires an analysis of all the facts and circumstances. In addition, this case clearly illustrates the IRS’ willingness to challenge bad debt deductions, even in instances in which the taxpayer has a strong position to claim such a deduction. Accordingly, taxpayers claiming a bad debt deduction should pay close attention to document all relevant facts supporting debt treatment and supporting the time at which a debt goes worthless, as the IRS seems willing to challenge even the strongest positions for this deduction.