Your client may be able to salvage a business bad debt deduction that can offset highly-taxed income, but this tax relief isn’t available for all business opportunities.
Let’s start with this basic premise: If it qualifies, a business bad debt is deductible against ordinary income, taxed at rates up to 37 percent. Conversely, a non-business bad debt is treated as a capital loss of more limited value.
To qualify for the business bad debt deduction, you must show that the debt is a bona fide debt arising from a creditor-debtor relationship where was:
- a legitimate expectation of repayment
- an intent to enforce that obligation
In other words, simply formalizing a loan arrangement is not enough to establish a bona fide debt. Similarly, producing a note or other legally enforceable document showing the debt isn’t, by itself, conclusive evidence of a bona fide debt. If a debt is a legitimate business bad debt, it is deducted in the year it becomes worthless.
In a new case, Yaryan, TC Memo 2018- 129, 8/15/18, a taxpayer and his spouse purchased a home from a real estate company in Colorado. Shortly after his retirement, the taxpayer hired the company as the general contractor to work on a greenhouse that they planned to build on their property.
After the work was completed, the firm’s owner approached the taxpayer to discuss its construction business. Generally, the company’s business model at that time was to build and market one new home at a time. The taxpayer believed that this business model was inefficient.
He suggested a new strategy in which the company would focus on building three homes at once. Eventually, the firm and the taxpayer entered into a joint venture whereby the company would purchase residential lots in its name, while the taxpayer would hold a secured interest in the lots for his contributions and a fee.
As part of the agreement, the taxpayer agreed to provide capital contributions for the purchase of vacant lots. To make a long story short, the venture went bust and the taxpayer ended up claiming a business bad debt that was challenged by the IRS, among other tax issues at stake.
Tax outcome: The Tax Court denied the deduction because the taxpayer wasn’t engaged in an active trade or business, unlike the real estate company. Instead, he was a mere investor, so the debt doesn’t qualify as a bona fide business bad debt. Thus, the Tax Court didn’t have to discuss the matter of when the debt became worthless.
When a client has a legitimate bad debt, make sure there’s intent to collect on it if the business goes south. For instance, your client might employ a collection agency or initiate legal action if there is a chance of recovery. Then, what the client finally has to pull the plug, the deduction can be deducted as a business bad debt.
Ken Berry, Esq., is a nationally known writer and editor specializing in tax, financial, and legal matters. During his long career, he has served as managing editor of a publisher of content-based marketing tools and vice president of an online continuing education company. As a freelance writer, Ken has authored thousands of articles for a...