by Chris Moss CPA
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How many of you all have ever loaned money or property through your business and have not been paid back? Have you ever loaned money or property to a friend and have not been paid back? Did you all know you can deduct either on your business or personal tax return a bad debt either as a business bad debt under IRS Section 166(a) and 166(b) or a nonbusiness bad debt under IRS Section 166(d)? However, the Government looks closely at your bad debts perhaps years later disallowing all your deductions in and IRS Bad Debt Audit. So if you loaned out some money or property that you want to deduct in 2015 as a bad debt, stay with us here on TaxView with Chris Moss CPA Tax Attorney to find out how to keep those bad debt deductions from being disallowed years later during and IRS Bad Debt Audit.
Bad Debts are not so bad when you get to write them off on your tax return. But what if you get audited as did Fred Cooper in Cooper v IRS US Tax Court (2015). The facts are simple: Cooper liked to make large sporadic loans to friends and business acquaintances. One of these loans was for almost $1M to Wolper Construction commencing in 2005 and due to be paid back in 2007. Wolper filed Chapter 11 in 2008 and eventually Chapter 7 in 2009. On advice of professional tax advisors Cooper amended his 2008 tax return in 2010 and deducted $750,000 bad debt deduction against ordinary income. The IRS audited years later in 2013 and disallowed the entire bad debt deduction for 2008. Cooper appealed to US Tax Court in Cooper vs IRS TC Memo 2015-191.
Judge Buch notes that Section 166 allows taxpayers to deduct any debt that becomes worthless within the taxable year. To be entitled to the deduction the taxpayer must show a bona fide debt based on a debtor-creditor relationship citing IRS Regulation 1.166-1(c). Business debts and nonbusiness debts are treated differently under Section 166. Nonbusiness debts are defined as debts not connected in connection with a trade or business. Unlike Business Bad Debts that are deducted directly against income, nonbusiness bad debts are short term capital losses with a maximum deduction of $3000 per year if there are no offsetting capital gains. Whether or not the debt is business or nonbusiness is a question of fact citing Rollins v Commissioner 276 F.2d 368 (4th Cir 1960). The business bad debt must be “proximately related” to the conduct of the trade or business, citing Litwin v US 983 F.2d 997 (10th Cir 1993).
Cooper argued before the Court that he was in the business of lending and therefore the deduction was a business bad debt. The Government argued otherwise citing that the facts do not support Cooper’s argument. The Court agreed with the IRS finding that there were five facts that showed Cooper was not a lender: 1. Cooper made only 12 loans over a six year period from 2005-2010. 2. Cooper only would lend money to friends and acquaintances. 3. Cooper did not use formal lending practices with no credit checks or collateral verification and there were no written promissory notes for 7 of the 12 loans. 4. Cooper did not publicly hold himself out to be a lender and 5. Cooper did not keep adequate contemporaneous business records. Many of the records given to the Court were constructed after the fact and were not considered credible.
The Court then went on to find that the nonbusiness bad debt was not wholly worthless in the year Cooper claimed the deduction in 2008. Cooper unfortunately was unable to show identifiable events to the Court that formed the basis of Cooper abandoning any hope of recovery citing Aston v Commissioner 109 US Tax Court 400 (1997). The facts unique to Cooper showed Cooper never claimed the debt to the US Bankruptcy Court, that Cooper listed the loan on his personal financial statement in 2009 as an asset, and that Cooper never sent Wolper a form 1099-C, cancellation of debt, nor was the IRS ever sent the 1096 form reporting the cancellation of the debt to Wolper. The Court therefore concluded that based on the facts, Cooper’s nonbusiness bad debt was not wholly worthless and therefore the deduction could not be sustained. IRS wins Cooper loses.
Our next case, Shaw v IRS US Tax Court (2013) also has simple facts. June Shaw had a large capital gain of over $1M in 2009 from the sale of an apartment building in 2008. In the same year as this gain, the facts show that in 2009 June Shaw loaned on a very short term basis over $800K to a company owned by her brother Kenneth Shaw. June Shaw was unable to get her loan paid back by her brother Kenneth in 2009 so she deducted this $800K as a capital loss bad debt against the $1M capital gain. The IRS audited years later and disallowed the entire bad debt deduction claiming there was no bona fide worthless bad debt to deduct. June Shaw appealed to US Tax Court in Shaw v IRS Tax Court 2013-170.
Judge Lauber opines that Section 166(a)(1) allows a deduction for any bona fide debt that becomes worthless within the taxable year. A bona fide debt is a debt that arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed sum of money, citing Section 1.166-1(c) of the IRS regulations. Transactions between family are subject to special extra scrutiny citing Caligiuri v Commissioner 549 F.2d 1155(8th Cir 1977). The Court observed that June Shaw provided no evidence that she checked out the credit worthiness of the company nor that she request assets be given to collateralize the loan. The facts showed further that June Shaw extended an unsecured line of credit that no third party lender would have approved. Finally that Court noted that June Shaw made no serious effort to obtain repayment nor did she send a letter demanding payment. Finally she never filed a law suit against the company. The Court easily concluded that the loan was not a bona fide loan and therefore not deductible under Section 166. IRS Wins June Shaw loses.
So how can you best create the facts you need to deduct a bad debt and sustain the deduction under Section 166 during an IRS bad debt audit years later? First, before you lend anyone any money or property make sure you have a written legal promissory note with real terms of repayment. Check their credit scores and make sure you get collateral on the loan. Obtain financials and a PFS from the borrower, just like a bank would ask for. Second, if you think the debt is going bad, retain a collection company to collect the debt and consider bringing legal action. About a year later if all else fails, then and only then can you claim on a tax return that you are deducting a bona fide bad debt that is wholly worthless and noncollectable. Finally, have your tax attorney attest to the steps you have taken to collect the debt and insert her contemporaneous statement into your tax return before you file. You will be glad you protected your bad debt deduction from Government adverse action when the IRS come knocking on your door years later to commence an IRS Bad Debt Audit.
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Chris Moss CPA Tax Attorney