The tax ramification of a bad debt deduction depends on whether it is a
business bad debt or a nonbusiness bad debt. A business bad debt is deductible
on the business tax return of the taxpayer as an ordinary loss and can generate
a net operating loss (NOL). A nonbusiness bad debt is deductible as a
short-term capital loss, subject to the $3,000 per year net capital loss
limitation.
The taxpayer in this case made a career out of lending money for
profit, both through business entities and out of his personal funds. One of
his personal loans to a commercial laundry wound up going bad. He deducted the
loss as a business bad debt which in turn created NOL carrybacks and
carryforwards. The IRS claimed it was a personal bad debt because the taxpayers
private lending was not a trade or business.
IRC section 166 allows a deduction for a bona fide debt that becomes
worthless within the tax year. To be treated as a business bad debt, the
regulations require that:- The debt be created or acquired in connection with the taxpayers
trade or business,- A bona fide debt existed between the taxpayer and his debtor, and- The debt became worthless in the year the bad debt deduction was
claimed.
For a money lending activity to be considered a trade or business, the taxpayer
must have been involved in the activity with continuity and regularity, with
the primary purpose of earning income or making a profit. The courts have
developed a non-exhaustive list of facts and circumstances to consider in
deciding whether a taxpayer is in the business of lending money:- The total number of loans made,- The time period over which the loans were made,- The adequacy and nature of the taxpayers records,- Whether the loan activities were kept separate and apart from the
taxpayers other activities,- Whether the taxpayer sought out the lending business,- The amount of time and effort expended in the lending activity, and- The relationship between the taxpayer and his debtors.
The IRS argued that even if the taxpayer had made enough loans over the
years, his source of funds was a family limited partnership (FLP) he managed
with his two sisters. Out of 89 loans made over a 14 year period, only 8 listed
the taxpayer as the lender. The rest listed the FLP as the lender.
The
court disagreed with the IRS in that the majority of those alleged to be FLP
loans were in fact made from the taxpayer’s personal trust. The taxpayer made
at least 66 loans over this period of time (either alone, or acting as trustee
of his trust) to a multitude of borrowers, easily exceeding $24 million. These
figures were more than sufficient to support the finding that the taxpayer’s
personal lending activities were continuous and regular by themselves.
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