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.
What becomes of any unused loss? She then can carry forward the remaining loss and claim it in an identical way on her returns for subsequent years until she uses it up.
What happens if the transaction is reviewed by an understandably skeptical IRS and the agency disputes her characterization of the loss as a business bad debt deduction? Then the burden falls on her to persuade the IRS that her “dominant motive” for the loan wasn’t investment. Rather, she made it to safeguard her job.
That’s a formidable assignment for her or anyone else who’s the sole or majority shareholder. Unsurprisingly, dominant motive disputes often wind up being resolved by the Tax Court.
She ought not to be surprised if the Tax Court sides with the IRS and decides that the dominant motive is investment protection. Was there any substantial investment motive present? If that’s the case, then the court says the loss is capital.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 250 and counting).
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...