When Can a Bad Debt Be Deducted for Tax Purposes? by LACEY STRACHAN
The Internal Revenue Code Section 166 allows taxpayers a deduction for debts that have become uncollectible, if certain requirements are met. These requirements were evaluated by the Tax Court recently in the case Cooper v. Commissioner, T.C. Memo 2015-191 (September 28, 2015), which denied a couple a deduction for a bad debt, on the grounds that the taxpayers did not prove that the debt became worthless during either of the tax years at issue.
Bona Fide Debt. Section 166(a) provides generally that “There shall be allowed as a deduction any debt which becomes worthless within the taxable year.”[i] A threshold issue is whether there is a bona fide debt, defined as a “debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”[ii] The regulations distinguish a bona fide debt from a gift or contribution to capital, which are not considered debts for purposes of Section 166.[iii]
Business Bad Debt vs. Nonbusiness Bad Debt. In the case of taxpayers other than corporations, Section 166 distinguishes business bad debts from nonbusiness bad debts, providing that a business bad debt can be deducted against a taxpayer’s ordinary income, whereas a nonbusiness bad debt must be treated as a short-term capital loss.[iv] The Code defines a business debt as a “debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.”[v] Taxpayers have the burden of proving that a bad debt loss is “proximately related” to the conduct of a trade or business, or that the debt was created in the course of a trade or business.[vi]
In Cooper v. Commissioner, the Tax Court rejected the taxpayers’ argument that an amount they had loaned to a real estate development business run by an acquaintance was a business bad debt, explaining that “the right to deduct bad debts as business losses is applicable only to the exceptional situations in which the taxpayer’s activities in making loans have been regarded as so extensive and continuous as to elevate that activity to the status of a separate business.”[vii] Factors that courts consider include: the total number of loans made and the time period over which the loans were made; the records kept by the taxpayer of the lending activity; whether the taxpayer’s loan activities were kept separate and apart from the taxpayer’s other activities; whether the taxpayer sought out the lending business; the amount of time and effort expended in the lending activity; the relationship between the taxpayer and his debtors; and whether the taxpayer used normal money-lending methods and practices.”[viii]
Although this was not an isolated loan and the taxpayer husband, Mr. Cooper, had made sporadic loans to friends and acquaintances over the years, the Tax Court held that his lending activities did not rise to the level of being in the business of lending money, for the following reasons: (1) Mr. Cooper made only 12 loans over a six-year period and did not devote a significant amount of time to his lending activity, especially given that he held an unrelated full-time job; (2) Mr. Cooper only lent money to friends and acquaintances; (3) Mr. Cooper did not following typical business formalities, such as performing credit checks, executing promissory notes, and protecting the collateral; (4) Mr. Cooper did not publicly hold himself out as being in the lending business or maintain a separate office or other business presence for his lending business; and (5) Mr. Cooper did not keep adequate business records, with the records produced at trial being created after the fact instead of contemporaneously.
As a result, the Court in Cooper determined that the taxpayers were not entitled to a business bad debt, limiting any deduction to a capital loss. The question then turned to whether the taxpayers had proved that the debt became wholly worthless during either 2008 or 2009, the years at issue in the case.
General Rule for Worthlessness. The Tax Court has stated that “[a] debt is ordinarily thought to become worthless in the year in which identifiable events clearly mark the futility of any hope of further recovery thereon.”[ix] A debt is considered worthless if the “surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment.”[x]
The Tax Court had stated that “worthlessness is not determined by an inflexible formula or slide rule calculation, but upon the exercise of sound business judgment.”[xi] In determining whether a debt is worthless, a “taxpayer must follow a rule of reason, avoiding alike the Scyllian role of the ‘incorrigible optimist’ and the Charybdian character of the ‘stygian pessimist.’”[xii] Although a subjective belief of worthlessness is not sufficient, a “bare hope that something might be recovered in the future constitutes no sound reason for postponing the time for taking a deduction.”[xiii] A taxpayer is “not required to postpone his entitlement to a deduction in the expectancy of uncertain future events.”[xiv]
In Cooper, the Tax Court held that Mr. Cooper did not establish that he had reasonable grounds to abandon any hope of recovery in either 2008 or 2009 (the years at issue), even though the debtor had declared bankruptcy.[xv] The Tax Court held that it is not sufficient to show that the debtor is in bankruptcy, because in some cases, a debt may not become worthless until a settlement in bankruptcy has been reached.[xvi] In Cooper, the Tax Court held that it was not until 2010 that the value of the assets in the bankruptcy estate were known and a determination of worthlessness could be made, because an asset of the bankruptcy estate was a mechanic’s lien that was of unknown value when the debtor filed for bankruptcy.[xvii] In contrast, the Tax Court has previously held that a loan that a taxpayer had made to his son-in-law was worthless because it was clear that the debtor at that time was insolvent, even though the debtor had not even declared bankruptcy.[xviii]
Moreover, the Tax Court noted that Mr. Cooper had not even treated the debt as worthless in 2008 and 2009, having listed the loan as an asset on a net worth statement on two occasions in 2009 and failing to claim the loan as a bad debt on his original filed returns for 2008 and 2009.[xix] It was not until 2010 that the taxpayers claimed the bad debt deduction on an amended return that they filed for 2008.[xx]
As the Tax Court cases demonstrate, worthlessness is a question of fact that depends on all of the facts and circumstances. Courts will consider not only the objective financial position of the debtor and his ability to repay the debt, but also whether the actions of the taxpayer-lender are consistent with a determination that there is no reasonable hope of recovery.
LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue domestic civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. She has considerable expertise in handling matters arising from the U.S. government’s ongoing civil and criminal tax enforcement efforts, including various methods of participating in a timely voluntary disclosure to minimize potential exposure to civil tax penalties and avoiding a criminal tax prosecution referral. Additional information is available at https://www.taxlitigator.com.
[i] IRC § 166(a).
[ii] Treas. Reg. § 1.166-1(c).
[iv] IRC § 166(d)(1).
[v] IRC § 166(d)(2).
[vi] Cooper v. Commissioner, T.C. Memo 2015-191 (September 28, 2015).
[vii] Id. (internal quotation marks omitted) (citing Imel v. Commissioner, 61 T.C. 318, 323 (1973); Sales v. Commissioner, 37 T.C. 576 (1961); Barish v. Commissioner, 31 T.C. 1280 (1959)).
[viii] Cooper v. Commissioner, T.C. Memo 2015-191.
[ix] James A. Messer Co. v. Commissioner, 57 T.C. 848, 861 (T.C. 1972).
[x] Treas. Reg. § 1.166-2(b).
[xi] Washington Institute of Technology, Inc. v. Commissioner, 10 T.C.M. 17, 20 (1951).
[xii] Minneapolis, St. Paul & Sault Ste. Marie R. R. Co. v. United States, 164 Ct. Cl. 226 (1964). The United States Court of Federal Claims has described the determination of worthlessness as follows: “It is obvious that there is no precise test for determining worthlessness within the taxable year and neither the statutory enactment, its regulations, nor the decisions attempt such an all-inclusive definition. From the numerous decisions, we are taught that a determination of whether or not a debt becomes worthless in a particular year must be confined to the fact[s] of the particular case. Furthermore, it is often impossible to select a single factor or ‘identifiable event’ which clearly establishes the time at which a debt becomes worthless and thus deductible. More often it is a series of events which in the aggregate present a picture establishing that the debt in question has become worthless. Such a decision of necessity requires a practical approach, not a legal test.…It must be flexible in nature, varying according to the circumstances of each particular case, so that whatever inferences a court might draw from a particular fact in another case are not binding on the examining court, although the same fact may be present.” Id.
[xv] Cooper v. Commissioner, T.C. Memo 2015-191.
[xviii] See Andrew v. Commissioner, 54 T.C. 239 (1970) (holding that it was irrelevant that the taxpayer had not demanded payment, because the law does not require the taxpayer to do a useless act); see also Shirar v. Commissioner, TC Memo 1987-492 (holding that a loan made by a taxpayer to his brother was worthless notwithstanding the fact that the taxpayer had not made any formal collection efforts, where his brother had informed the taxpayer after his business had failed that he would be unable to pay the loans).