Bad Credit Results in No Bad Debt Deduction

When it comes to taking a bad debt deduction, the IRS tends to scrutinize more closely, especially if the loan is from a friend or family member. The courts have developed various factors that they consider in such disputes, including whether the borrower could have secured a loan from a third party.

Recently, in Scheurer v. Commissioner, T.C. Memo. 2017-36, the court addressed this issue in a case where the borrower had bad credit. The case highlights the importance of proper documentation and active involvement in the business activity, as well as the need to show that a bona fide debt existed and that it was proximately related to the trade or business–particularly when the borrower has bad credit.

Facts & Procedural History

The taxpayer is a financial planner.  His friend owned a business that made robocalls to consumers with heavy credit card debt that bore high-interest rates in an effort to sell their interest rate reduction services.

The friend did not have good credit and could not establish merchant credit card processing accounts for the business. The taxpayer agreed to use his good credit to open the accounts, which he did by forming a separate partnership with his friend for this purpose.

When the friend’s business made a sale, the merchant company would withhold its fee and a 10% reserve and remit the funds to the partnership. The partnership would then withhold 10% and remit the funds to the friend’s business. The robocall business experienced financial difficulties, which resulted in the taxpayer advancing funds to the business.  The funds were not repaid and the taxpayer reported a bad debt deduction for the advances.

The IRS audited the partnership return and disallowed the loss.  The court had to decide whether the bad debt deduction was allowable.

Bad Debt Deductions

Under the tax code, business bad debts are permitted, and for non-corporate taxpayers, the loss is deductible in the tax year in which the debt becomes completely worthless. The loss is only allowed if the taxpayer was engaged in a trade or business and the debt was proximately related to the taxpayer’s trade or business.

To qualify for the deduction, the taxpayer must participate in the activity with continuity and regularity and must have a primary purpose of generating income or profit (i.e., not a hobby loss). Moreover, merely managing an investment does not qualify as a trade or business. Additionally, for the debt to be deductible, it must be a bona fide debt in the form of a true loan. If a third-party lender would not have extended funds on the same terms, there is an inference that the advance is not a true loan.

Factors Establishing No Bad Debt

The court concluded that the advances were not a true loan, as a third-party lender would not have made the loan. The court noted that this was the very reason why the taxpayer had to provide the merchant accounts, as his friend’s business had bad credit. The court also noted that the taxpayer did not properly document the loan. There was no promissory note, no fixed or determinable amount due, no specified interest rate, no principal due date, and no requirement of security.

The court also concluded that the taxpayer was not in the trade or business. He worked full-time as a financial planner. He did not actively work in this business with any regularity. The court also noted that it did not find the taxpayer to be a credible witness. These factors lead the court to conclude that the bad debt deduction was not allowable.

The Takeaway

This court case highlights the importance of proper documentation and adherence to IRS regulations when claiming bad debt deductions, especially when the loan is from a friend or family member. The IRS often challenges bad debt deductions, and courts use several factors to determine their validity, including whether a third-party lender would have made the loan, whether the taxpayer was engaged in a trade or business, and whether the debt was well-documented.

Taxpayers should be aware of these factors and take necessary steps to limit the IRS’s ability to challenge bad debt deductions. In this case, the court concluded that the bad debt deduction was not allowable because the taxpayer failed to meet these requirements, resulting in a disallowed loss and penalties. The result in the case may have been different if the taxpayer was able to show that third-party lenders would have made the loan, that he actively worked in the business, and that the loan was well documented.