Even though some of the decisions leave heads spinning, all the recent cases, when put into perspective, give a framework for safety structuring a business versus nonbusiness debt. If things turn sour, the difference will be a cappital loss instead of an ordinary business deduction.

Although a very common item to taxpayers, bad debt deductions are not without controversy. The amount, timing, and type of bad debts (business or nonbusiness) often fall into the grey area of taxation.

IRC Sec. 166(a) provides the general authority for a bad debt deduction, stating, "There shall be allowed as a deduction any debt which becomes worthless during the year."

Bona Fide Debt Requirement

To deduct a debt, the debt must be bona fide, i.e., the relationship must be based on a valid and enforceable obligation to pay a fixed or determinable sum of money. Generally, a debtor-creditor relationship does not exist where repayment is based or dependent on profits earned by the "debtor." If the facts indicate such, the "debt" may be treated by the IRS as a contribution of capital or an investment instead of a loan. If previously included in income, the obligation is considered to be enforceable, even if unenforceable under state law.

Example. In 1991, Brentor Brothers, an accrual-basis partnership, accrued $15,000 of receivables from gambling debts, which are unenforceable in their state. The debt became worthless in 1992. The partnership was entitled to a bad debt deduction in 1992.

Evidence of Worthlessness

The question as to when a debt is uncollectible and therefore worthless is one of fact and has been the subject of much litigation. Mere refusal of the debtor to pay is not sufficient proof of worthlessness. Even adjudication of bankruptcy does not always justify a bad debt deduction for total worthlessness. If the debt is secured or there exists a reasonable probability that some assets would be available for unsecured creditors, only a partial deduction can be taken. If the debtor is solvent, bad-debt losses due to compromise of the debt may not be deductible unless the reduction is under the terms of a composition agreement.

Time of Deduction

Cash-basis taxpayers generally will not have reported income due them as an open account receivable. Since the basis of the receivable is zero, no deduction is allowed when the debt becomes uncollectible. However, income of a cash-basis taxpayer that is evidenced by a note is reportable when the note is received. Therefore, notes receivable of cash-basis taxpayers do have a basis and would be charged off upon becoming worthless.

Accrual-basis taxpayers generally report income as it is earned. Therefore, they may take a bad-debt deduction on accounts or notes that have become worthless during the year. However, the item must have been included in income either for the year of the deduction of the bad debt or in a previous year.

Business or Nonbusiness Bad Debts

The tax treatment of bad debts differs greatly depending on whether it is a business or nonbusiness debt. Business bad debts are deductible as an ordinary business expense. Therefore, there are no limitations on the amount of the deduction. The deduction can create or increase a net operating loss, and, for sole proprietors, the deduction is for adjusted gross income. A deduction for the partial worthlessness of a business bad debt is also permitted. In contrast, a nonbusiness bad debt is deductible only as a short-term capital loss, and no deduction is permitted for partial worthlessness. The taxpayer must wait until the debt is totally worthless.

The regulations state that the question of business v. nonbusiness debt is a question of fact, determined by the relation which the debt bears to the trade or business of the taxpayer.

On the other hand, the use of the funds is irrelevant in determining the status of the bad debt. The following examples are adopted from the regulations:

Example 1. Linn has a receivable from Jones that was incurred in a trade or business capacity. Linn sells the business, but retains the receivable. The debt is considered a business debt even though Linn is no longer in business.

Example 2. Linn sells the business to Smith, but sells the receivable to Green, who is not engaged in the trade or business. The debt is considered nonbusiness.

Example 3. Linn dies, leaving the business, including the receivable, to his son. The debt is considered business.

Example 4. Linn dies, leaving the business to his son and the receivable to his daughter, who is not engaged in the trade or business. The debt is considered nonbusiness.

An employee who loans money to his employer with the motive of retaining his job has a case for claiming a business bad debt, but what if the employee is also an investor in the company? The Supreme Court ruled in Generes that the test must be whether the dominant motive was business. In that case, a taxpayer who owned 44% of a construction company and was paid $12,000 per year for serving as president on a part-time basis, loaned the company a considerable amount of money. He sought to deduct the losses on such loans as business because a significant motive in loaning the money was business. The Court, in deciding for the government, said that the test must be that of a dominant business motive because among other reasons--

* The code considers the distinction between business and nonbusiness to be important.

* Without the dominant motive test, employee-shareholders would always have at least a significant business motive. The thrust of Generes has been to make business bad debt treatment more difficult to attain. In Burton the president of an advertising agency loaned money to his largest client, a brewing company. Though he argued that his dominant motive was to protect his position with the ad agency, both the Tax Court and the Sixth Circuit found the business motive was not the dominant motive. In Hough an attorney advanced money to a wholly-owned broadcasting company. The debt was held to be nonbusiness because--

* At the time he was practicing law full-time;

* He took no promissory notes;

* He never billed the corporation for services rendered; and

* He was never paid anything for the legal, management, and consulting services performed for the corporation.

Operationalizing the dominant business motive test has of course been difficult. The courts have applied three tests in this respect:

1. The amount of the taxpayer's investment in the corporation;

2. The amount of the taxpayer's salary from the corporation; and

3. Other sources of income available to the taxpayer.

In Pierce a taxpayer formed a partnership with two others to publish a newsletter. Later he requested the partnership be dissolved and his money returned. The partnership gave him a note for his investment. When the note became worthless, he deducted the loss as a business bad debt. The IRS claimed that the loan was simply his partnership interest, and that at best he had simply a capital loss. However, the Tax Court held that the taxpayer's motive in making the loan was to market his consulting services. Thus the debt was considered a business bad debt.

In Adelson the taxpayer provided financial services to clients for a monthly fee. His clients were new growth-oriented companies who in many cases would be unable to obtain financing from traditional sources. In these cases, he would sometimes loan the client money. Out of six loans that went bad, the Court of Claims found three to be business and three to be nonbusiness. The relationship between the amount of consulting fees and the amount of the investment was considered very important.

In Rider the shareholder/employees had worked for many years at their two family-owned corporations. They guaranteed certain corporate obligations under a bankruptcy reorganization. The Third Circuit, following Generes, placed great weight on comparing salaries with investment. Since the taxpayers presented no evidence of the value of their salaries or investments at the time they executed the guarantee (a rather surprising omission by their attorney given TABULAR DATA OMITTED Generes), they did not carry the burden of proving the debts were business.

Look at Salary Payments

Lack of salary payments is a critical negative factor if the creditor is an employee, as is a low ratio of salary payments to the amount invested. In Holland a sole shareholder advanced $100,000 to his corporation and guaranteed another $50,000 of debt. During a five-year period he was never paid any salary, although during the year the debt was written off a salary of $15,000 was accrued. In denying a business deduction for the bad debts, the Sixth Circuit said ". . . it seems far more likely that Holland guaranteed the note in an effort to protect his very real investment in the company and not his nebulous interest in a phantom salary."

In Davenport, the taxpayer was president and eventually controlling stockholder of a finance company. During the period 1968-1971, he invested more than $130,000 in stock and loans to the corporation. During the same period his gross salary as president was between $7,200 and $12,000. The Tax Court said, "We simply cannot believe that petitioner would spend so much money to protect this amount of income |salary ... he was virtually the only shareholder. Under these circumstances he had little fear of losing his job as president."

Thin Capitalization

The combination of thin capitalization and debt proportionate to stock holdings is considered by the courts to indicate equity instead of debt. In Waller the taxpayer was a plant manager of a business that did business with a company called NTR. He and other shareholders of NTR loaned money to it. A district court noted that no interest was paid, the notes were not paid by the repayment date, they were in proportion to the stock, there was a high degree of risk because the corporation continuously lost money, and the capitalization was thin, all factors indicating equity, not debt. Finally, a dominant business motive was not present because only a small percentage of his salary could be said to be generated by business between his employer and NTR.

Another case involving a thinly capitalized corporation was Leuthold. Here, a 45% shareholder advanced a corporation money for about eight years. Promissory notes were not executed, no interest was provided for, and there were no formal maturity or repayment dates. Further, the corporation was thinly capitalized and had never made a profit. Not surprisingly, the Tax Court held the advances constituted equity, rather than loans.

Presence of Equity

The presence of equity does not preclude a deduction if the taxpayer can show that he was engaged in a joint venture. However, the loss is then deductible under IRC Sec. 165, rather than as a bad debt. In Stanchfield the taxpayer loaned substantial sums of money to his son-in-law's construction company. The agreement provided for a share of profits but did not mention losses because none were intended. The IRS argued that these were nonbusiness bad debts. However, the Tax Court held these advances were contributions to capital of a joint venture and were deductible under IRC Sec. 165 as business losses (not as bad debts).

The situation in Hunsaker was more ambiguous. A man and his father were both in the real estate business and from time to time formed joint ventures and partnerships. The father formed a land development corporation, and the son loaned a considerable amount of money to it. In denying business bad debt treatment, the Ninth Circuit said " ... there is no evidence, other than Richard's after the-fact testimony at the trial, that they had jointly invested in the particular development projects undertaken by the father's corporation. Nor is there any evidence that Richard's own business stood to be affected in any way by the success or failure of the corporation."

Loans to Clients

Does loaning money to a client to help the client complete a transaction constitute a business motive? Not always, according to the Tax Court. In Greenspan an attorney loaned money to clients to facilitate real estate transactions. Although Greenspan testified the loan would not have been made but for the fact Smith was a client and the sale would not have been closed without it, the Tax Court said "We think that the 'dominant motivation' test of Generes requires something more than the existence of a 'but for' relationship." The court did not say what such a relationship might be.

Krasnow was an interesting case involving attribution of a loan. Could a wife's loan to support a business in which her husband was an employee be attributed to him (He directed her to make the loan)? A District Court said no, "He was simply not a party to the loan. TABULAR DATA OMITTED The loan did not expose him to any potential loss; and he was not entitled to demand repayment."

Another case involving a relative's debt hinged on a different issue. In Lair a father who had retired from farming guaranteed debts of his son. Unfortunately for the father, Reg. 1.166-9(e) states that a guarantor who pays the debt of another must have received reasonable compensation for the guarantee to deduct the bad debt. In the case of a relative, the compensation must be in the form of cash. Although the father argued that the rent payments received constituted cash compensation, the Tax Court found the rent payments to be unrelated to the debt guarantee and disallowed the bad debt deduction.

In one of a few cases holding for the taxpayer, in Mann a taxpayer who brokered business acquisitions loaned about $300,000 to a company controlled by his brother. He had little ownership interest during the period in question, and received broker's fees of $430,000 from acquisitions made by the company. Despite their relationship, the debt was considered to be business.

In Arstein a shoe stylist and manager loaned money to enable the corporation for which he worked to sell shoes. He had no stock investment in the company and made the loan to protect his reputation. Not surprisingly, the Tax Court held for the taxpayer and allowed a business bad debt write-off. In Rosati the president of a construction company guaranteed loans made by banks to the company for which he worked. The Tax Court held that the taxpayer was primarily motivated to preserve his job and salary when he executed the guarantee. Hence, the debt was a business bad debt.

A more recent case involving a CPA, Lagoy, was found in favor of the taxpayer, but with a twist. The CPA lent money to two related corporations for their use in acquiring a new business. His purpose in lending the money was to obtain the accounting work of the new business. After loaning the money, the deal fell through and the two corporations were unable to repay the debt. However, instead of deducting the debts as they became worthless, he arbitrarily deducted $60,000 to offset his other income in the first year and deducted the remaining $40,000 in the second year. Although the court allowed the business bad debt deduction, it determined the deduction should have been $80,000 in the first year and $20,000 in the second. As a result, negligence penalties and IRC Sec. 6661 additions to tax were imposed with respect to the latter year's return.

A case involving a questionable application of Generes occurred in Tennessee Securities. The Gaw brothers, stockholder-employees in a securities underwriting firm, personally guaranteed loans made to a start-up company that they hoped would go public and generate underwriting fees for their company. When the start-up company failed to pay the debt, it was paid by the underwriting company instead of the brothers. The IRS denied a deduction to the corporation (because it was not its debt), imputed income to the shareholders, and denied them a business bad-debt deduction. The Court said, among other things, that "... there is no evidence that TSI was in danger of failing altogether if CFA did not develop its potential as a client. Thus we cannot suppose that the CFA loan guarantee was critical to the preservation of the Gaw's business income." The Sixth Circuit seems to be stretching here; Generes never referred to a critical business need, simply to a "dominant business motive."

It is possible for a taxpayer not to be in the line of business of the debtor, but be in the business of promoting, or lending to, businesses. In Carpenter a man of great wealth who derived most of his income from dividends, but who guaranteed loans of small businesses for a small fee, suffered some bad debt losses. Even though most of his income was from other sources, a District Court found that he was in the business of loaning money. Therefore, the debts were business debts.

In Farrington, a taxpayer had promoted 11 businesses over a 14-year period and sold ten of them for a profit. A 12th business was not successful, and he claimed a business bad debt. The IRS argued the actions simply constituted long-term investing. However, a District Court held that he was in the business of promoting businesses. Hence, the debt was a business debt.

A Framework for Success

As can be seen from the above court cases, the business/nonbusiness bad debt issue is very clouded. However, some strategies which would increase the likelihood of success include the following:

1. Make the loans as businesslike as possible. Have signed notes, maturity dates, and reasonable rates of interest.

2. If the creditor is an employee of the corporation, the employee should be drawing a salary. The motive of job preservation is weak if the job carries no financial remuneration.

3. The loans should not be unreasonable when compared to the salary. Such an unreasonable relationship would indicate an investment rather than business motive.

4. The presence of a thinly capitalized corporation indicates the loans are equity, and the result would be a denial of a bad debt deduction.

5. Ownership of a majority interest in the corporation indicates an ability to control one's own job, and therefore weakens the need to loan money to protect the job.

6. The more stock the taxpayer owns, the more likely the courts are to assume an investment motive for loaning money rather than a business motive.

The distinction between business and nonbusiness treatment of bad debts is ambiguous and confusing. Further, it has considerable significance to individual creditors. Therefore, careful planning is necessary to maximize the likelihood of a business bad debt deduction.

Gary L. Maydew, PhD, is an Associate Professor at Iowa State University.