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Providing capital to entities or individuals that go bust — tax implications

Written by Antar P. Jones, Esq., LL.M.

Published in complinet.com on March 25th 2011

Over the past several years and until now, much has been discussed concerning the tax exposure to borrowers who are forgiven of debt. Understandably, much of the discourse concerning this matter has involved the forgiveness of debts related to the real estate market as a result of the bursting of the housing bubble and the advent of the credit default swap crisis. Generally, when the debt of a taxpayer is canceled, the amount of the cancelled debt may be considered income for income tax purposes, unless an exception provided by statute applies. The rules concerning the cancellation of indebtedness are complex and evolving. Less has been discussed concerning the tax consequences to the providers of capital to individuals or entities where such investments become worthless or partially worthless.

In many instances, but not all, investors may take certain deductions when their investments go bad. The Internal Revenue Code (IRC) and the regulations under them provide for many categories of investors whose investments have gone south: (1) sellers who reacquire real property in partial or full satisfaction of indebtedness that arose from the sale; (2) those who receive amounts on the retirement or sale or exchange of debt instruments; (3) those who sustain losses during a taxable year who are not compensated for by insurance; (4) those whose securities become worthless during a taxable year; and (5) those whose debt becomes worthless (or, in the case of corporations, partially worthless) during the taxable year.

The rules regarding these categories of taxpayers are complex. Accordingly, taxpayers who believe that they may be included in at least one of the above categories at some point in time, including up to seven years ago, should speak with their firm’s accounting professional.

This article will explore some of the basic issues concerning the tax consequences of those whose debt becomes worthless or partially worthless during the taxable year, as the rules governing those taxpayers tend to be more favorable than the rules governing the other categories of taxpayers. Individuals and entities who take a deduction concerning worthless or partially worthless debts take a “bad debt” deduction pursuant to Section 166 of the IRC.

It should be noted, however, that the favorability of the tax treatment of the above categories of taxpayers tends to coincide with the degree of financial injury endured. Thus, to the extent that a taxpayer may choose the category in which to be included, the taxpayer should balance its potential tax treatment with other considerations, such as the mitigation of the loss of its investment.

 WHAT IS BAD DEBT?

To qualify for a bad-debt deduction, the bad debt must first be a bona fide debt; that is, a debt which arises out of a debtor- creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. Also, the debt must not be evidenced by a security. Specifically, the debt cannot be a bond, debenture, note, certificate, or other evidence of indebtedness, issued by a corporation or by a governmental or political subdivision thereof, with interest coupons or in registered form. The debt must not be defined by the IRC as a “loss.” Losses generally cannot be deducted by individuals unless the losses were incurred in a trade or business, or were incurred in a transaction entered into for profit. In contrast, individuals may only take a bad-debt deduction if the debt is a non-business debt. Also, the debt must not be a retired debt instrument as, subject to narrow exceptions, those instruments are treated by another IRC provision.

It should be noted that typical bad debts are loans to clients and suppliers, certain debts of political parties, certain debts of insolvent partners, certain business loan guarantees and certain sales of mortgaged properties. However, loans to corporations that are actually capital contributions are not bad debts.

WHO MAY TAKE A BAD-DEBT DEDUCTION?

Corporate taxpayers may take an ordinary deduction for any business bad debt that becomes worthless during the taxable year, and for any business bad debt that becomes partially worthless during the taxable year, but only to the extent that it’s worthless.

In determining whether a debt is worthless in whole or in part, the relevant district director at the Internal Revenue Service (IRS) will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. Legal action is not required to prove worthlessness. Where the circumstances indicate that a debt is worthless, and uncollectible and legal action would not result in satisfaction of execution on a judgment, a showing of these facts will suffice as evidence of a worthless debt. However, the taxpayer must prove that worthlessness occurred in the year in which the deduction was claimed. Thus, it appears that the taxpayer must prove that the debt had value the year before.

If a debt is recoverable only in part, the district director of the IRS may allow a corporate taxpayer take a deduction in an amount that has become worthless to the extent the debt has been “charged off” during the taxable year. Charging off a debt essentially means that the taxpayer has evidenced that the debt was uncollectible on its books. Also note that the statute and its regulations have provided the district director with broad latitude to disallow deductions due to partially worthless bad debt.

Non-corporate taxpayers may take a short-term capital loss deduction for a non-business business debt that became worthless within the taxable year. A “non-business” debt is a debt other than a debt created or acquired in connection with a trade or business of the taxpayer or a debt the loss from worthlessness of which is incurred in the taxpayer’s trade or business. Also, worthless debts arising from unpaid wages, salaries, fees, rents and similar items of taxable income shall not be treated as bad debts, unless the income such items represent has been included in the tax return of income for the year for which the deduction as a bad debt has been claimed, or for a prior year.

HOW MUCH OF A DEDUCTION CAN A TAXPAYER TAKE FOR BAD DEBT?

Generally, the basis for determining the amount of the bad debt is the cost of the debt. In other words, to determine the amount of a bad debt deduction, a taxpayer will first determine the cost of the debt. The cost of the debt may in certain circumstances be different than the face amount of the obligation. In addition, one should be mindful that the Regulations have provided for specific situations concerning a debt’s basis. For example, in computing taxable income, if a taxpayer values his notes or accounts receivable at their fair market value when received, the amount deductible shall be limited to that fair market value. Also, with respect to bankruptcy claims, only the difference between the  amount  received  in distribution of the assets of the bankrupt and the amount of the claim may be deducted as a bad debt. Finally, with respect to claims against a decedent’s estate, the excess of the amount of the claim over the amount received by a creditor of a decedent in distribution of the assets of the decedent’s estate may be considered a worthless debt.

WHEN CAN A TAXPAYER TAKE A BAD-DEBT DEDUCTION?

If a taxpayer did not deduct a bad-debt deduction on its original return for the year it became worthless, the taxpayer can file a claim for a credit or refund. A taxpayer may take a bad-debt deduction the later of seven years from the date the original return was due (not including extensions) or two years from the date the taxpayer paid the tax for totally worthless debts. This is a remarkable statutory allowance because generally, the limitations period for filing a claim is three years. If the claim was for a partly worthless bad debt, the taxpayer may file the claim by the later of three years from the date the taxpayer filed the original return, or two years from the date the taxpayer paid the tax.

HOW DOES A TAXPAYER TAKE A BAD-DEBT DEDUCTION?

A taxpayer filing an income tax return for the first taxable year which the taxpayer is entitled to a bad-debt deduction may in theory select one of two methods in taking bad debts into account: (1) as a deduction in respect of debts which become worthless in whole or in part; or (2) as a deduction for a reasonable addition to a reserve for bad debts. However, there is some authority that the second method is reserved only for certain financial institutions that have previously used the reserve method. Once a taxpayer has selected one of the two methods, the taxpayer should continue to use that method for all subsequent taxable years unless the IRS grants permission to use the other method. In any event, a taxpayer should provide a statement of facts with its tax return that substantiates any bad debt. The forms used to file a claim are the following:

  • Form 1040X for sole proprietors or farmers;
  • Form 1120X for corporations;
  • Form 1102S for S corporations (check box H(4));
  • Form 1065 for partnerships (check box G(5)).

BEST PRACTICES

  • Maintain a close, working relationship with your company’s accounting professional, to the extent that he or she is aware of any potential transactions that may qualify for a bad-debt deduction now or in the future.
  • For loans, to the extent possible, be sure that the loan does not constitute a “security” as defined by the IRC and have an attorney state as much in the loan instrument.
  • Have an attorney consider providing in every contract with a lendee, vendee, employer, partner, and the like, the circumstances under which a bad debt may arise concerning the transaction.
  • In addition, for potentially large bad debts, have general counsel consider providing in every contract with a lendee or vendee, employer, partner and the like, terms requiring the annual review of the debtor’s financial health so that in the event there is a bad debt the year of worthlessness or partial worthlessness may be more easily ascertainable. Then, if practicable, document the financial health of the debtor annually to evidence the year of worthlessness or partial worthlessness of the bad debt.

Antar P. Jones, Esq., practices law at the Law Office of Antar P. Jones, PLLC. Jones has experience advising clients concerning complex tax planning, tax controversy and estate litigation. He has also represented common clients in federal court and administrative hearings.

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