Business Bad Debt vs. Nonbusiness Bad Debt

Post Date: 9/11/17
Last Updated: 9/11/17


Cross References - Owens, T.C. Memo. 2017-157, August 10, 2017

The tax ramifications of a bad debt deduction depends on whether it is a business bad debt or a nonbusiness bad debt. A business bad debt is deductible on the business tax return of the taxpayer as an ordinary loss and can generate a net operating loss (NOL). A nonbusiness bad debt is deductible as a short-term capital loss, subject to the $3,000 per year net capital loss limitation.

The taxpayer in this case made a career out of lending money for profit, both through business entities and out of his personal funds. One of his personal loans to a commercial laundry wound up going bad. He deducted the loss as a business bad debt which in turn created NOL carrybacks and carryforwards. The IRS claimed it was a personal bad debt because the taxpayer’s private lending was not a trade or business.

IRC section 166 allows a deduction for a bona fide debt that becomes worthless within the tax year. To be treated as a business bad debt, the regulations require that:
- The debt be created or acquired in connection with the taxpayer’s trade or business,
- A bona fide debt existed between the taxpayer and his debtor, and
- The debt became worthless in the year the bad debt deduction was claimed.

For a money lending activity to be considered a trade or business, the taxpayer must have been involved in the activity with continuity and regularity, with the primary purpose of earning income or making a profit. The courts have developed a non-exhaustive list of facts and circumstances to consider in deciding whether a taxpayer is in the business of lending money:
- The total number of loans made,
- The time period over which the loans were made,
- The adequacy and nature of the taxpayer’s records,
- Whether the loan activities were kept separate and apart from the taxpayer’s other activities,
- Whether the taxpayer sought out the lending business,
- The amount of time and effort expended in the lending activity, and
- The relationship between the taxpayer and his debtors.

The IRS argued that even if the taxpayer had made enough loans over the years, his source of funds was a family limited partnership (FLP) he managed with his two sisters. Out of 89 loans made over a 14 year period, only 8 listed the taxpayer as the lender. The rest listed the FLP as the lender.

The court disagreed with the IRS in that the majority of those alleged to be FLP loans were in fact made from the taxpayer’s personal trust. The taxpayer made at least 66 loans over this period of time (either alone, or acting as trustee of his trust) to a multitude of borrowers, easily exceeding $24 million. These figures were more than sufficient to support the finding that the taxpayer’s personal lending activities were continuous and regular by themselves.

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