What Does It Take To Claim a Business Bad Debt Deduction?

Do you know what it takes to support a bad debt deduction?

I am not talking about a business sale to a customer on open account, which account the customer is later unable or unwilling to pay. No, what I am talking about is loaning money.

Then the loan goes south, other partially or in full.

And I –as the CPA - find out about it, sometimes years after the fact. The client assures me this is deductible because he/she had a business purpose – being repaid is surely a business purpose, right?

Unless you are Wells Fargo or Fifth Third Bank, the IRS will not automatically assume that you are in the business of making loans. It wants to see that you have a valid debt with all its attributes: repayment schedule, required interest payments, collateral and so forth. The more of these you have, the better your case. The fewer, the weaker your case. What makes this tax issue frustrating is that the tax advisor is frequently uninformed of a loan until later – much later – when it is too late to implement any tax planning.

Ronald Dickinson (Dickinson) and Terry DuPont (DuPont) worked together in Indianapolis. DuPont moved to Illinois to be closer to his children. DuPont was having financial issues, including obligations to his former wife and support for his children.

Dickinson started up a new business, and he reached out to DuPont. Knowing his financial issues, Dickinson agreed to help:

Anyway, I want to reiterate again my commitment to you financially, and what I would expect from you in paying me back. I am not going to prepare a note, or any form of contract, because I trust you to be honest about this matter, just like all of the other people I have loaned money.

Anyway, I agree you loan you money to get settled in over here, and help you out financially as long as I see our new company is working, and you are going to work as hard as you did for me the last time we worked together.”

Sounds like Dickinson was a nice guy.

Between 1998 and 2002, Dickinson wrote checks to DuPont totaling approximately $27,000.

DuPont acquired a debit card on a couple of business bank accounts, and he helped himself to additional monies. He was eventually found out, and it appears that he was not supposed to have had a debit card. By 2003 the business relationship ended.

Dickinson filed a lawsuit in 2004. He wanted DuPont to pay him back approximately $33,000. The suit went back and forth, and in 2009 the Court dismissed the lawsuit.

Dickinson, apparently seeing the writing on the wall, filed his 2007 tax return showing the (approximately) $33,000 as a bad debt. He included a long and detailed explanation 0f the DuPont debacle with his return, thereby explaining his (likely largest) business deduction to the IRS.

The IRS disallowed the bad deduction and wanted another $15,000-plus from him in taxes. But - hey – thanks for the memo.

Dickinson took the matter pro se to Tax Court.

And there began the tax lesson:

(1)   Only a bona fide debt qualifies for purposes of the bad debt deduction.

(2)   For a debt to be bona fide, at the time of the loan the following should exist:

a.      An unconditional obligation to repay

b.      And unconditional intention to repay

c.       A debt instrument

d.      Collateral securing the loan

e.      Interest accruing on the loan

f.        Ability of the borrower to repay the alleged loan

Let’s be honest: Dickinson was not able to show any of the items from (a) to (f). The Court noted this.

But Dickinson had one last card. Remember the wording in his letter:

            … just like all of the other people I have loaned money.”

Dickinson needed to trot out other people he had made loans to, and had received repayment from, under circumstances similar to DuPont. While not dispositive, it would go a long way to showing the Court that he had a repetitive activity – that of loaning money – and, while unconventional, had worked out satisfactorily for him in the past. Would this convince the Court? Who knows, because…

… Dickinson did not trot out anybody.

Why not? I have no idea. Without presenting witnesses, the Court considered the testimony to be self-serving and dismissed it.

Dickinson lost his case. He took so many strikes at the plate the Court did not believe him when he said that he made a loan with the expectation of being repaid. The Court simply had to point out that, whatever Dickinson meant to do, the transaction was so removed from the routine trappings of a business loan that the Court had to assume it was something else.

Is there a lesson here? If you want the IRS to buy-in to a business bad debt deduction, you must follow at least some standard business practices in making the loan.

Otherwise it’s not business.