Bad Debt Deduction Not Allowed Until Business Fails

Published Categorized as Federal Income Tax, Tax, Tax Loss
Bad Debt Deduction Not Allowed Until Business Fails
Bad Debt Deduction Not Allowed Until Business Fails

If you lend money to a failing business and the business eventually fails, can you take a bad debt deduction?  And if so, when?  The U.S. Tax Court addressed this in Cooper v. Commissioner, 143 T.C. 10, which provides an opportunity to consider the question.

Facts & Procedural History

The Coopers started Pixel in 1983.  Pixel was in the business of designing and manufacturing audio and video signal processing products. Specifically, Pixel designed products to measure and correct errors in the synchronization of sound and video images.

Mr. Cooper was employed by Pixel and executed a promissory note in 1995 to advance funds to Pixel as working capital.  When televisions changed from standard definition to high definition in the mid-to-late-2000s, many of Pixel’s products became obsolete.

In an effort to better compete in the marketplace, Pixel began developing a product known as Liptracker to correct lip synchronization errors in high definition televisions.  Pixel contracted with an Indian company to complete the software development necessary for Liptracker.  The Indian company could not fulfill its promise to develop the Liptracker software and Pixel was unable to proceed with the development on its own.

In 2008 Pixel faced financial difficulty. It had no new products in development–aside from the stalled Liptracker product–and few older products that were still marketable. Its gross receipts were in excess of $525,000 in both 2005 and 2006 but decreased significantly in 2007 and 2008.

Pixel continued business operations through at least 2012.  Pixel was the assignee of many patents in 2008 and thereafter and had an active licensing agreement with another company.

Pixel’s gross receipts were $92,603, $148,968, $26,912, $22,500, and $22,500 for 2008, 2009, 2010, 2011, and 2012, respectively.  Pixel had total year end assets each year from 2008 through 2012 in excess of $172,000, including more than $319,000 in both 2011 and 2012.

Mr. Cooper continued to advance funds to Pixel under the terms of the promissory note throughout 2008.  Mr. Cooper concluded at that time that Pixel could not pay the outstanding balance on the Pixel note, and the Coopers treated the balance as a non-business bad debt on their 2008 Federal income tax return.

The IRS disallowed the 2008 non-business bad debt deduction and the Coopers asked the tax court to review this determination.

When is a Debt Worthless?

The issue in Cooper was whether the debt was worthless in 2008.

Generally, a debt is worthless in the year the debt becomes worthless, which is indicated by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery.

This is a facts and circumstances determination. The taxpayer must prove that the debt had value at the beginning of the taxable year and that it became worthless during that year. A mere belief of worthlessness is not sufficient.

In Cooper, the taxpayer did not initiate any type of litigation to recover the amounts they lent Pixel under the terms of the promissory note.  There wasn’t a clear event, like a court case that was lost or abandoned, to point to.

Worthless Means No Going Concern

The Coopers argued that the promissory note became worthless in 2008 following the Indian company’s abandonment of the Liptracker program. This action, according to petitioners, gave rise to the conclusion that there was no hope of recovering the outstanding amounts under the promissory note.

The court did not agree, noting that:

Pixel had total year end assets each year from 2008 through 2012 in excess of $172,000, including more than $319,000 in assets in 2011 and 2012 . It appears to us that Pixel remained a going concern well past 2008. The outcome of Pixel’s arrangement with the Indian company and the failure of the Liptracker program do not support petitioners’ claim that there was no longer any prospect of recovery of their loans to Pixel. More importantly, the proper inquiry in this case is not whether petitioners acted reasonably in their recovery efforts, but whether sufficient objective facts show that the debt became worthless during the year in question. Here, the facts do not support such a determination.

Pixel experienced a decline in its business in 2008, but its gross receipts increased in 2009. Petitioners as co-trustees of the Cooper Trust continued to advance funds to Pixel under the terms of the promissory note throughout 2008. Indeed, petitioners advanced $148,255 to Pixel under the terms of the promissory note between July and December 2008. We do not find it credible that petitioners would have advanced nearly $150,000 to Pixel after July 2008 if they believed the promissory note had been rendered worthless in July 2008 by the difficulties with the Liptracker program. The evidence shows that Pixel had substantial assets at 40 the end of the 2008 tax year and that its gross receipts increased in 2009. Moreover, at the very least, Pixel was entitled to an indefinitely continuing annual royalty of $22,500 and owned rights in several other patents.

Thus, the court concluded that the business owner was not entitled to a bad debt deduction for a loan made to a failing business prior to the time the business actually failed.

The Takeaway

This scenario is very common, as taxpayers and the IRS often disagree as to when a loss is worthless and therefore deductible.

The IRS normally argues that the loss was worthless in a prior tax year that is closed, such that the taxpayer cannot now claim a deductible loss. The IRS may also argue–as it did here–that the loss is deductible at some future point.

This is usually the case where the loss is capital in nature and the taxpayer does not have sufficient capital losses in the future years to be able to benefit from the bad debt deduction.

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