In Norgaard v. United States, No. 16-12107-FDS (D. Mass. 2018), the court addressed whether a personal loan made to a closely held corporation can be deducted as a bad debt when the business goes out of business. The case highlights why it is important to document loans made to corporations.
The Facts & Procedural History
The taxpayers were husband and wife. They opened a supply store in 2008. The company was a corporation.
The company obtained a Small Business Administration loan in 2010, but wasn’t able to repay the loan. Both husband and wife were personally liable for the loan. The taxpayer-wife obtained a mortgage on her residence to pay the loan. The wife paid off the SBA loan and another loan, but did not impose any requirements on the company that it would repay her for the loan. The company then closed in 2010. The taxpayer claimed a bad debt deduction under Sec. 166, which was audited and then denied by the IRS.
The Sec. 166 Bad Debt Deduction
Section 166 provides for a deduction for bad debts that become worthless in the tax year.
Most disputes involving bad debts are over the character of the loss. Section 166 makes a distinction between business and nonbusiness bad debts. Business bad debts can be deducted against ordinary income whether wholly or partially worthless during the year. The deduction is allowed to the amount the debt becomes worthless. Nonbusiness bad debts can only be deducted when the debt becomes completely worthless in the year and then only as a capital loss.
Other disputes involving bad debts are over the year the deduction is allowable. The cases turn on whether there is an identifiable event that triggers the deduction. No matter which year the taxpayer claims the deduction and takes the deduction on their return, the IRS will usually take the position that the taxpayer selected the wrong year.
Other disputes involving bad debts address whether there was a bona fide debt, to begin with. The regulations say that a bona fide debt is one “which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Gifts and capital contributions are not considered bona fide debts.
This case involved a dispute as to whether the debt was a bona fide debt.
What is a Bona Fide Debt?
There is a bona fide debt if there was an actual good-faith intent to establish a debtor-creditor relationship at the time the loan was made. This exists if the purported debtor intends to repay the loan and the creditor intends to enforce repayment. The courts generally consider the following factors in making this determination:
- The name given to the certificates evidencing the indebtedness,
- The presence or absence of a fixed maturity date,
- The source of payments,
- The right to enforce repayment,
- Participation in management as a result of the advances,
- The status of the advances in relation to debts owed to regular corporate creditors,
- Thin or adequate capitalization,
- The risk involved in making the advances,
- The identity of interest between creditor and shareholder,
- The use to which the advances were put,
- The ability to obtain loans from outside lending institutions,
- Failure to repay advances on the due date,
- The intent of the parties, and
- The payment and accrual of interest.
No one factor is conclusive, so all factors have to be considered.
Documenting a Bona-Fide Debt
The court in Norgaard, the court did not expressly address the factors for a bona fide debt in detail. Instead, the court summarily concluded that:
plaintiff’s payment discharged her obligation as a guarantor (and a borrower) of the SBA loan. She was the majority shareholder of a small corporation. There was no written evidence of indebtedness (such as a note), no collateral or other security, and no fixed repayment plan. Repayment, if it were to occur at all, was from the company’s future earnings. In short, the objective economic reality is that the repayment of the loan was in fact a form of capital contribution. Section 166 does not apply, and plaintiff accordingly cannot claim a bad debt deduction.
It should be noted that some of these factors might be in the taxpayer’s favor. For example, absent her health issues, the business may have had the ability to repay the loans and there may have been evidence that the taxpayer’s intent was to create a debtor-creditor relationship.
But setting that issue aside, there were several steps the taxpayer could have taken to help ensure they were able to take the bad debt deduction. This may have included documenting the loan with legal documents (such as a promissory note), recording the loan as a loan on the business’ balance sheet, authorizing the loan and receipt of loan proceeds in the corporate minutes, and paying or accruing interest on the loan. It does not appear that the taxpayer took any of these steps in this case. These steps would have gone a long way to establishing that the debt was bona fide.
A Loss Doesn’t Mean All is Lost
Where Sec. 166 is not available for bad debts like in this case, taxpayers may still be able to deduct the loss under Section 165. Section 165(g) provides for a loss for worthless securities. This type of loss would not be for the bad debt, but rather, it would be for the taxpayer-wife’s loss on the corporation stock once the business stopped operating under state law.
The court opinion, in this case, does not address this alternative argument. It appears that the taxpayers did not raise this alternative argument–which is common (here is a similar case where the issue was not raised). They may not have done so given that worthless security losses are generally capital in nature. Capital losses can usually only be taken against other capital gains or up to $3,000 a year. This might not have been an acceptable outcome for the taxpayers in this case. A capital loss may be better than no loss, even if the loss carries forward to future tax years.