I often receive queries from shareholder-employees of closely held companies who loan their own money or act as guarantors for loans to the corporations. They seek advice on the tax consequences of their loans.
I caution them that they should be aware that when those kinds of loans go sour, as too often occurs, the tax rules on deductions of bad debts might turn out to be more bad news for them. Consequently, it’s prudent for them to know, in advance of deciding to take an ownership stake in their companies, how the Internal Revenue Service and the courts look at worthless loans.
Let’s say a shareholder-employee made the loan or guaranty as an employee in order to protect her job. In that case, the loss qualifies as a business bad debt. This entitles her to take an ordinary-loss write-off for the entire amount in the year that she incurs the loss.
Suppose, instead, that she made the loan in order to protect her investment as a stockholder. Then the loss that she incurs is usually deductible under the restrictive rules for nonbusiness bad debts. The law treats that kind of loss as a short-term capital loss. It might take years for her to deduct the entire amount.
For the year the loan proves to be uncollectible, the law allows her to use the loss to offset any capital gains and then use as much as $3,000 of the remaining loss as an offset again ordinary income from, for instance, her wages or other kinds of compensation.
About Julian Block
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com.