The IRS often challenges bad debt deductions–particularly when the loan is from a family member or friend. The courts have developed several factors that they consider in these disputes. One of these factors is whether the borrower would have been able to secure a loan from a third party. The court recently addressed this in in Scheurer v. Commissioner, T.C. Memo. 2017-36, in a case where the borrower had 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 friends 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
The Code allows for business bad debts. For non-corporate taxpayers, the loss is allowable in the year the debt becomes completely worthless. This loss is only allowable if the taxpayer was engaged in a trade or business and the debt was proximately related to the trade or business. The taxpayer must participate in the activity with continuity and regularity and his primary purpose for engaging in the activity must be for income or profit (i.e., not a hobby loss). The management of an investment does not qualify. Even then, there must be a bona fide debt in the form of a true loan. If a third-party lender would not have lent funds on the same terms, an inference arises 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 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.