It is virtually inevitable that all of us will at one time or another incur financial losses in our business and personal lives. One frequently occurring type of loss is a bad debt. Whether made in the course of business, or to a friend or relative, sometimes a loan simply cannot be repaid despite the best intentions of the debtor, and if there is little or no prospect that repayment can be made in the future you may have a bad debt. From a tax standpoint, the question is how to handle bad debts, and what steps to take to at least derive the maximum tax benefits available from them. Although this subject is fraught with complexities, we will outline the basic principles here to give you an idea as to whether the bad debt rules may apply to you.

The first step is ascertaining that a real debt exists. There must be a valid and legally enforceable obligation to pay you a fixed or "determinable" sum of money. Loans between family members, or other related parties such as corporations and their shareholders, are particularly scrutinized to make sure that they are really debts rather than disguised gifts, dividends, or contributions to the corporation’s capital. Therefore, if you are contemplating a loan to a related party, you must ensure that you treat the transaction as a true loan by taking the steps that an arm’s-length lender would take, such as putting it in writing and charging a reasonable rate of interest.

It then must be determined if, and when, the debt has become totally or partially worthless, i.e., a bad debt. The problem here is that the IRS often required taxpayers to play a guessing game. If a taxpayer claims a bad debt loss when nonpayment is only probable, rather than a virtual certainty, the Service may disallow the loss as premature because there is some possibility of repayment in a later year. On the other hand, if the taxpayer waits until repayment is clearly hopeless, the Service may maintain that the debt was really worthless in an earlier year and the loss should have been taken then. Because of potential statute of limitations problems, we generally recommend that the loss be claimed in the earliest possible year that it can reasonably be argued to be worthless. There are a number of indicators of worthlessness, including the debtor’s bankruptcy, but no one of them is decisive; it is the totality of circumstances that is determinative.

Once it is established that a bad debt exists, the business or nonbusiness nature of the debt decides the outcome. As you might expect, a business bad debt must be created or acquired or become worthless in the course of your trade or business. If you conduct a business in the form of a corporation, generally any debt held by the corporation is a business debt. Any debt not falling into the business category is a nonbusiness debt. A nonbusiness debt must be completely worthless before a loss can be taken, whereas a loss on a business bad debt can be taken when partial worhtlessness can be established. Furthermore, nonbusiness bad debts are subject to the limitations on capital losses. Business bad debts, on the other hand, are deductible as ordinary losses in full against your other income.

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