It's A Bad Debt Deduction, Isn't It?

William Delaney, EA

The classic answer to that question is---well, it depends.  Let’s look at an all too frequent example.  In June Shaw v. Comm., 116 AFTR 2d (CA-9), 11/18/2015 (affirming a Tax Court decision), the issue was whether or not the taxpayer was entitled to a bad debt deduction for loans made to her corporation, SRG Corp. (owned by June Shaw and her mother).  Shaw established and funded a revolving line of credit for the corporation and, over a period of time, advanced more than $800,000 against the unsecured line of credit, even though the finances of the business were shaky, to say the least. 

Shaw claimed to have made an oral request for repayment of $5,000 in 2009.  Her brother Kenneth, President of SRG, informed her that the corporation could not repay the loans.  Shaw did not initiate any collection effort or legal action, nor is there a record that she consulted an accountant or other competent financial advisor.  Instead, she deducted the entire amount of $808,475 as a bad debt on her 2009 personal income tax return.  The deduction was disallowed by the IRS.

Quoting from the Appeals Court decision:  “Shaw failed to show that her advances to SRG constituted a bona fide debt that arose from a debtor-creditor relationship…she continued to advance money to SRG despite its unstable finances…she produced no evidence beyond her and her brother Kenneth’s testimony that SRG had become insolvent.”

Reg. 1.166-2(b) allows a deduction for worthlessness if it can be shown that legal action to enforce payment would probably not result in collection of the amount in question.  It is difficult to apply this standard if the debtor (in this case SRG) does not maintain books and records, has title to assets of unspecified value, does not prepare and file income tax returns, and has not initiated a bankruptcy filing.  Something of value must be there and available to creditors.  What it is, and how much it is worth, has not been determined.  Keep in mind, also, that the creditor claiming the bad debt deduction is also a major shareholder of the debtor corporation.

On appeal, Shaw argued that the advances were capital contributions (if it isn’t a bad debt it must be something).  However, since this issue was not raised at the Tax Court (i.e. lower court level), the Appeals Court refused to give it consideration (it was waived).

So, if it is worthless, follow formalities.  Post and reconcile books and records; prepare and file tax returns; liquidate assets and turn them into cash.  Then make your case for a full or partial bad debt deduction.  Otherwise, you will lose it every time.