Bitcoin and Fred

I am going to dedicate this post to Fred.

Fred likes to talk about Bitcoin. He is a believer. He may as well be on the payroll.

I do not want to talk about blockchain or cryptocurrencies or any of that.

Let’s talk about the taxation of the thing, in case Fred has gotten to you.

As I write this Bitcoin is selling for around $15 grand.

On January 1, 2017 – less than a year ago – it sold for around $1 grand.

COMMENT: There is a reason why we are still working, folks.

There are even Bitcoin ATMs. I understand there around 70 or so locations around Miami alone. You can tap into one if you are going to the Orange Bowl at the end of this month.

Mind you, if you withdraw dollars-for-Bitcoins you probably have a tax consequence.

You see, the IRS has said (in 2014) that Bitcoin is not a currency. Given this thing’s propensity to swing hundreds if not thousands of dollars of day, it makes sense that it is not a currency. Currencies are supposed to have some stable value, at least until politicians run them into the ground.

No, Bitcoins are property, like stocks or a mutual fund. Like a stock or mutual fund, you have a tax consequence on the sale.

Let’s use the following numbers for the sake of discussion:

          Bought on 1/1/17                    $1,000

          Cashed-in on 12/31/17           $16,500

Let’s say you cash-in a Bitcoin while you are at the Orange Bowl. What have you got?

Way I see it, you have ...

    $16,500 (proceeds) - $1,000 (cost) = $15,500 gain

You are supposed to report $15,500 as income on your tax return.

What type of income is it?

I see a buy. I see a sell. I would argue this is capital gain. It would be short-term, as you did not own it for a year.

Let’s throw a curve ball.

Let’s say that you did some work for somebody in 2016. The paid you with that Bitcoin on January 1, 2017 – the one worth $1,000 at the time.

What are your tax consequences now?

You got paid with a Bitcoin worth $1,000. You have $1,000 of ordinary income. If you got paid for work, it is also subject to self-employment tax.

Then you sell it.

I see the following …

   $1,000 (ordinary) + $15,500 (capital gain) = $16,500   

This is what happens when Bitcoin is considered “property” rather than “currency.” It would be the same as you writing checks on your Fidelity or Vanguard mutual fund. Every time you do you are selling some of your mutual fund. And it all gets reported to the IRS at year-end.

Except that most of Bitcoin does not get reported to the IRS at year-end. Not yet, at least. In fact, in 2015 only 802 people reported Bitcoin on their tax return. You know that doesn’t make sense.

Which is why the IRS served a “John Doe” summons on Coinbase in November, 2016. Coinbase is an exchange for virtual currencies like Bitcoin and Ethereum. A “John Doe” summons substitutes a group or class or people for a specific person. It could be as easy as “anyone who sold more than $600 of Bitcoin between 2013 and 2015.”

Coinbase fought back, of course, but in the end the two wound up compromising. Coinbase will not provide 100% of its account data, but the IRS is getting information on over 14,000 account holders and almost 9 million transactions.

Bitcoin and other virtual currencies have become the new overseas bank accounts. It is time to come clean on this stuff, folks.

And yes, I believe there will be IRS reporting – akin to what the stock brokerages do – in the near-enough future. The government is flipping the sofa cushions for every nickel it can find. Until they get us to a 100% tax rate, they are going to keep looking for new sofas.

Someone – probably Fred - was telling me about a Bitcoin credit card.

That is a tax nightmare

Why?

Say that you bust to Starbucks in the morning. You put your coffee on the card. You stop for fuel – on the card. You go to lunch – on the card. You stop at the dry cleaners and Krogers on the way home – both on the card.

You have 5 “sales” that day. Each one has a cost, and who knows how we are going to come up with that number. Say that you do something comparable almost every work day. I will probably “fee discourage” you from using me as your tax advisor.

BTW, a similar thing can occur if you accept Bitcoin as payment for your services. Say that you are an independent contractor and two or three of your clients pay you in Bitcoin. You are going to have to price the Bitcoin every time you get paid with one, as your “proceeds” are its value on the day you receive it.

That is an accounting hassle.

Can you think of a nightmare scenario?

I  can.

What if you get paid with Bitcoin next year when it is worth $20,000. You hold onto it. Let’s say Bitcoin drops to $9,000 by December 31, 2018. You bring me the info for your taxes. How much do you have to report as income from that Bitcoin?

You have to report $20,000.

But it is only worth $9,000 now!

Yep. That is how it works since Bitcoin is not considered a currency.

What can I do to get my taxes down? Should I sell it?

Now you have a different problem. If that thing is a capital asset – and we said earlier that it was – you will have a capital loss upon sale. You will report a $11,000 capital loss on your return.

And unless you have capital gains to absorb those losses, you continue to have tax problems. Capital losses are allowed to offset only $3,000 of your “other” (read: Bitcoin) income on your tax return. You get no bang on the remaining $8,000 ($11,000 - $3,000), at least until the following year when you can use another $3,000. 

Don’t forget that you are also paying self-employment taxes on that $20,000 and not on $9,000.

This is ridiculous. If I were you, I would fire me as your tax advisor.

I do not accept Bitcoin for my fees, but I am waiting for someone to bring it up. I might do it for an isolated transaction or two. 

But no way am I using a Bitcoin credit card.

When The IRS Says Loan Repayments Are Taxable Wages

Here is a common-enough fact pattern:

(1) You have a company.

(2) You loan the company money.

(3) The company has an unprofitable stretch.

(4) Your accountant tells you to reduce or stop your paycheck.

(5) You still have bills to pay. The company pays them for you, reporting them as repayments of your loan.

What could go wrong?

Let’s look at the Singer Installations, Inc v Commissioner case.

Mr. Singer started Singer Installations in 1981. It was primarily involved with servicing, repairing and modifying recreational vehicles, although it also sold cabinets used in the home construction.

After a rough start, the business started to grow. The company was short of working capital, so Mr. Singer borrowed personally and relent the money to the company. All in all, he put in around two-thirds of a million dollars.

PROBLEM: Forget about the formalities of debt: there was no written note, no interest, no repayment schedule, nothing. All that existed was a bookkeeping entry.

The business was growing. Singer had problems, but they were good problems.

Let’s fast-forward to 2008 and the Great Recession. No one was modifying recreational vehicles, and construction was drying up. Business went south. Singer had tapped-out his banks, and he was now borrowing from family.

He lost over $330 grand in 2010 and 2011 alone. The company stopped paying him a salary. The company paid approximately $180,000 in personal expenses, which were reported as loan repayments.

The IRS disagreed. They said the $180 grand was wages. He was drawing money before and after. And – anyway – that note did not walk or quack like a real note, so it could not be a loan repayment. It had to be wages. What else could it be?

Would his failure to observe the niceties of a loan cost him?

Here is the Court:

We recognize that Mr. Singer’s advances have some of the characteristics of equity – the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule …”

This is going to end poorly.

 … but we do not believe those factors outweigh the evidence of intent.”

Wait, is he going to pull this out …?

 … because intent of parties to create [a] loan was overwhelming and outweighed other factors.”

He won …!

However, we cannot find that all of the advances were loans.”

Then what would they be?

While we believe that Mr. Singer had a reasonable expectation of repayment for advances made between 2006 and 2008, we do not find that a similarly reasonable expectation of repayment existed for later advances.”

Why not, Sheldon?

 After 2008 the only source of capital was from Mr. Singer’s family and Mr. Singer’s personal credit cards.”

And …?

No reasonable creditor would lend to petitioner.”

Ouch.

The Court decided that advances in 2008 and earlier were bona fide loans. Business fortunes changed drastically, and advances made after 2008 were not loans but instead were capital contributions.

This “no reasonable creditor would lend” can be a difficult standard to work with. I have known multimillionaires who became such because they did not know when to give up. I remember one who became worth over $30 million – on his third try.

Still, the Court is not saying to fold the company. It is just saying that – past a certain point – you have injected capital rather than made a loan. That point is when an independent third party would refuse to lend money, no matter how sweet the deal.

Why would the IRS care?

The real-world difference is that it is more difficult tax-wise to withdraw capital from a business than it is to repay a loan. Repay a loan and you – with the exception of interest – have no tax consequence.

Withdraw capital – assuming state law even allows it – and the weight of the tax Code will grind you to dust trying to make it taxable – as a dividend, as a capital gain, as glitter from the tax fairy.

It was a mixed win for Singer, but at least he did not have to pay taxes on those phantom wages.

The Qualified Small Business Stock Exemption

Let’s say that you are going to start your own company. You talk to me about different ways to organize:

(1) Sole proprietor – you wake up in the morning, get in your car and go out there and shake hands. There is no paperwork to file, unless you want to get a separate tax ID number. You and your proprietorship are alter-egos. If it gets sued, you get sued.

(2) Limited liability company – you stick that proprietorship in a single-member LLC, writing a check to your attorney and secretary of state for the privilege. You gain little to nothing tax-wise, but you may have helped your attorney (and yourself) if you ever get sued.

(3) Form a corporation - a corporation is the old-fashioned way to limit your liability. Once again there is a check to your attorney and secretary of state. Corporations have been out there long before LLCs walked the land.

You then have to make a decision as to the tax flavor of your corporation: 

a.    The “C” corporation – think Krogers, Proctor & Gamble and Macy’s. The C is a default for the big boys – and many non-bigs. There are some goodies here if you are into tax-free reorganizations, spin-offs and fancy whatnot.

Problem is that the C pays its own tax. You as the shareholder then pay tax a second time when you take money out (think a dividend) from the C.  This is not an issue when there are a million shareholders. It may be an issue when it is just you.

b.    The “S” corporation – geared more to the closely-held crowd. The S (normally) does not pay tax. Its income is instead included on your personal tax return. Own 65% of an S and you will pay tax on 65% of its income, along with your own W-2, interest, dividends and other income.

This makes your personal return somewhat a motley, as it will combine personal, investment and business income into one. Don’t be surprised if you are considered big-bucks by the business-illiterate crowd.

The S has been the go-to corporate choice for family-owned corporations since I have been in practice. A key reason is avoiding that double-tax.

But you can avoid the double tax by taking out all profits through salaries, right?

There is a nerdy issue here, but let’s say you are right.

Who cares then?

You will. When you sell your company.

Think about it. You spend years building a business. You are now age 65. You sell it for crazy money. The corporation pays tax. It distributes whatever cash it has left-over to you.

You pay taxes again.

And you vividly see the tax viciousness of the C corporation.

How many times are you going to flog this horse? Apple is a multinational corporation with a quarter of a trillion dollars in the bank. Your corporate office is your dining room.

The C stinks on the way out.

Except ….

Let’s talk Section 1202, which serves as a relief valve for many C corporation shareholders when they sell.

You are hosed on the first round of tax. That tax is on the corporation and Section 1202 will not touch it.

But it will touch the second round, which is the tax on you personally.

The idea is that a percentage of the gain will be excluded if you meet all the requirements.

What is the percentage?

Nowadays it is 100%. It has bounced around in prior years, however.

That 100% exclusion gets you back to S corporation territory. Sort of.

So what are the requirements?

There are several:

(1) You have to be a noncorporate shareholder. Apple is not invited to this soiree.

(2) You have owned the stock from day one … that is, when stock was issued (with minimal exceptions, such as a gift).

(3) The company can be only so big. Since big is described as $50 million, you can squeeze a good-sized business in there. BTW, this limit applies when you receive the stock, not when you sell it.

(4) The corporation and you consent to have Section 1202 apply.

(5) You have owned the stock for at least 5 years.

(6) Only certain active trades or businesses qualify.

Here are trades or businesses that will not qualify under requirement (5):

(1) A hotel, motel, restaurant or similar company.

(2) A farm.

(3) A bank, financing, leasing or similar company.

(4) Anything where depletion is involved.

(5) A service business, such as health, law, actuarial science or accounting.

A CPA firm cannot qualify as a Section 1202, for example.

Then there is a limit on the excludable gain. The maximum exclusion is the greater of:

(1) $10 million or

(2) 10 times your basis in the stock

Frankly, I do not see a lot of C’s – except maybe legacy C’s – anymore, so it appears that Section 1202 has been insufficient to sway many advisors, at least those outside Silicon Valley.

To be fair, however, this Code section has a manic history. It appears and disappears, its percentages change on a whim, and its neck-snapping interaction with the alternative minimum tax have soured many practitioners.  I am one of them.

I can give you a list of reasons why. Here are two:

(1) You and I start the company.

(2) I buy your stock when you retire.

(3) I sell the company.

I get Section 1202 treatment on my original stock but not on the stock I purchased from you.

Here is a second:

(1) You and I start the company.

(2) You and I sell the company for $30 million.

We can exclude $20 million, meaning we are back to ye-old-double-tax with the remaining $10 million.

Heck with that. Make it an S corporation and we get a break on all our stock.

What could make me change my mind?

Lower the C corporation tax rate from 35%.

Trump has mentioned 15%, although that sounds a bit low.

But it would mean that the corporate rate would be meaningfully lower than the individual rate. Remember that an S pays tax at an individual rate. That fact alone would make me consider a C over an S.

Section 1202 would then get my attention.

Almond Not-Joy

How much do you know about almond trees?

I know they are water-intensive and they come from California. I am uncertain whether they can be used for furniture. I presume they make good firewood.

So what would be a tax angle to this topic?

Growing almond trees.

Which gets us to farm taxation.

Farmers want (usually) to be cash-basis. This means that they report revenue when they receive cash and deduct expenses when they pay cash. It makes for relatively easy accounting, as one can almost get to a tax return from adding together 12 bank statements.

Then there are those issues.

I will give you one:

You buy a tractor-trailer load of seed and fertilizer late in December. Can you deduct it?

The issue here is whether you have incidental or nonincidental supplies. Incidental supplies (think printer paper to an accountant’s office) is deductible when purchased. Nonincidental supplies (think refilling an underground fuel tank of a trucking company) might be deductible only when used and not before.

Spend some big bucks on that fuel and the trucking company is keenly concerned about the answer.

Likewise, spend big bucks on seed and feed and the farmer is also keen on the answer.

Farmers have some nice tax bennies in the Code, and a large one is being able (in many cases) to use the cash basis of accounting. The Code furthermore allows farmers to deduct that year-end seed-and-feed (with some limitations) when purchased.

Nice.

That covers a lot of tax territory for row crops (that is: one growing season).

Let’s go next to orchards. Apples. Pears.

Almonds.

What new issue do we have here?

For one, orchards take years to become productive. There is no crop in the early years.

Is there any difference in the tax treatment?

Yep. It’s a sneaky one, too.

Let us talk about “uniform capitalization.” We have touched on this topic before, but never concerning almond trees. I am pretty sure about that.

The idea here is that the tax Code wants one to capitalize (that is, not immediately deduct) certain costs associated with inventory, self-produced assets any certain other specialized categories.

Almond trees are sort-of, kind-of “self-produced.”

Here is the fearsome tax beast in its canopied jungle home:

26 U.S. Code § 263A - Capitalization and inclusion in inventory costs of certain expenses

            (a) Nondeductibility of certain direct and indirect costs

(1) In general In the case of any property to which this section applies, any costs described in paragraph (2)—

(A) in the case of property which is inventory in the hands of the taxpayer, shall be included in inventory costs, and

(B) in the case of any other property, shall be capitalized.

I would argue that almond trees are “other property” per (a)(1)(B) above.

(2) Allocable costs The costs described in this paragraph with respect to any property are—

(A) the direct costs of such property, and

(B) such property’s proper share of those indirect costs (including taxes) part or all of which are allocable to such property.

Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.

The (B) above worries me. If this applies, then we have to “capitalize” real estate taxes on those trees.

Let’s look further at the definition of “property”:

(b)Property to which section applies Except as otherwise provided in this section, this section shall apply to—

(1) Property produced by taxpayer

Real or tangible personal property produced by the taxpayer.

(2) Property acquired for resale

(A) In general

Real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.

OK, I am getting worried. That (b)(1) sounds a lot like the almond trees. They are being “produced” (I guess) while they are growing and nonproductive.

Is there an out?

Here is something:

            (d)Exception for farming businesses

(1) Section not to apply to certain property

(A)In general This section shall not apply to any of the following which is produced by the taxpayer in a farming business:

(i) Any animal.

(ii) Any plant which has a preproductive period of 2 years or less.

I am zeroing-in on (d)(1)(A)(ii).

What is the growing (“preproductive”) period for almond trees?

Google says more than 2 years.

We are hosed.

We have to capitalize real estate taxes. 

COMMENT: Folks, that means “not deduct.” It gets expensive fast.

You know what else gets pulled-in via the gravitational pull of Sec 263A(a)(2)(B) above?

Interest.

We better not have any bank debt.

Arrggghhh! We have bank debt, meaning we have interest. We are going to have to capitalize that too.

The way this is going the only thing we are going to be able to deduct is the postage for the envelope in which we are sending a big check to the IRS.

We began the discussion by talking about how the cash basis of accounting lets farmers deduct stuff when they pay for them. Then we marched through the Code to find another section that tells us that we cannot deduct what we could deduct only a moment before.

COMMENT: I have heard a common lament over my years in practice: when to stop researching? There is no hard answer, but this case is an example of why tax practitioners fear and ask the question.

Our case this time was Wasco Real Properties I, LLC et al v Commissioner, for the home gamers.

What’s Fair Got To Do With It?

I am reading a tax case with an unfortunate result.

It does not seem that difficult to me to have planned for a better outcome.

I have to wonder: why didn’t they?

Let’s set it up.

We have a law firm in New York. There is a “heavy” partner and the other partners, which we will call “everybody else.” The firm faced hard times, and “everyone else” kept-up their bleed rate (the rate at which they withdraw cash), with the result that their capital accounts went negative.

COMMENT: A capital account is increased by the partner’s share of the income and reduced by cash withdrawn by said partner. When income goes down but the cash withdrawn does not, the capital account can (and eventually will) go negative. 

Let’s return to our heavy partner.

He was concerned about the viability of the firm. He was further concerned that New York law imposed on him a fiduciary responsibility to assure that the firm be able to pay its bills. I applaud his sense of responsibility, but I have to point out that any increased uncertainty over the firm’s capacity to pay its bills might have something to do with “everybody else” taking out too much cash.

Just sayin’.

Our partner’s share of firm income was almost $500 grand.

Problem is that the cash did not follow the income. His “share” of the income may have been $500 grand, but he left around $400 grand in the firm to make-up for the slack of his partners.

And you have one of those things about partnership taxation:   

·      The allocation of income does not have to follow the allocation of cash.

There are limits to how far one can push this, of course.

Sometimes the effect is beneficial to the partner:

·      A partner tales out more cash than his/her share of the income because the partnership owns something with big-time depreciation. Depreciation is a non-cash expense, so it doesn’t affect his/her distribution of cash.

Sometimes the effect is deleterious to the partner:

·      Our guy took out considerably less cash than the $500K income.

Our guy did not draw enough cash to even pay the taxes on his share of the income.

OBSERVATION: That’s cra-cra.

What did he do?

He reported $75K of income on his tax return. Seeing how did not receive the cash, he thought the reduction was “fair.”

Remember: his partnership K-1 reported almost half a million.

The number on his personal return did not match what the partnership reported.

COMMENT: By the way, there is yet one more form to your tax return when you do not use a number reported by a partnership. The IRS wants to know. He might as well just have booked the audit.

Sure enough, the IRS sent him a notice for over $140,000 tax and $28,000 in penalties.

Off to Tax Court they went.

And he had … absolutely … no … chance.

Partnerships have incredibly flexible tax law. There is a reason why the notorious tax shelters of days past were structured around partnerships. One could send income here, losses there, money somewhere else and muddy the waters so much that you could not see the bottom.

In response, Congress and the IRS tightened up, then tightened some more. This area is now one of the most horrifying, unintelligible stretches in the tax Code.  It can – with little exaggeration – be said that all the practitioners who truly understand partnership tax law can fit into your family room.

Back to our guy.

The Court did not have to decide about New York law and fiduciary responsibility to one’s law firm or any of that. It just looked at tax law and said:

Your income did not match your cash. You set this scheme up, and – if you did not like it – you could have changed it. Once decided, however, live with your decision.

Those are my words, by the way, and not a quote.

Our law partner owed the tax and penalties.

Ouch and ouch.

I must point out, however, that the law firm’s tax advisors warned our guy that his “fiduciary” theory carried no water and would be disregarded by the IRS, but he decided to proceed nonetheless. He brought much of this upon himself.

What would I have recommended?

For goodness’ sake, people, change the partnership agreement so that the “everybody else” partners reported more income and our guy reported less. It is fairly common in more complex partnerships to “tier” (think steps in a ladder or the cascade of a fountain) the distribution of income, with cash being the second – if not the first – step in the ladder. The IRS is familiar with this structure and less likely to challenge it, as the movement of income would make sense.

Another option of course would be to close down the law firm and allow “everybody else” to fend for themselves.

I would argue that my recommendation is less harsh.

The Mary And Brad Story

"With respect to petitioner wife’s Federal income tax for 2008, the Internal Revenue Service … determined a deficiency of $106,733 and an accuracy-related penalty of $21,347 under section 6662(a). With respect to petitioners’ joint federal tax for 2010, the IRS determined a deficiency of $100,924 and a section 6662(a) penalty of $20,185.”

Someone went into Tax Court for a quarter of a million dollars. Let’s check it out.

Oh, oh. The issue was whether the taxpayers had a business or nonbusiness bad debt. If they did not, then other tax dominoes would tumble, such as whether a net operating loss existed.

We have Mary Bell. She was single in 2008. She married in 2010. They lived in Texas.

Mary had an MBA, and through 2010 she worked at Blockbuster Corp. You may recall how that turned out, and since 2011 Mary had been a partner with a private equity 

firm.

Her husband also brought some financial chops to the relationship. He was involved with real estate loans, but he lost his job with the 2009 crash. His health thereafter became an issue, but he hoped to get back into the business. His previous clients would eventually have their loans mature, and he wanted to be there when they refinanced.

Our story involves Mary.

Before marrying, Mary dated Brad. Brad was unemployed but full of hope and hype. He was working on a comic strip called “In the Rough,” involving golf.

Mary was making a couple of nickles, and she loaned Brad $75,000. Mary did not go through the due diligence a bank would do, though: investigate his credit rating, request tax returns, obtain other financial information.

She loaned him another $50,000. Brad, being a mature and responsible guy, bought a Hummer with it. He clearly was a keeper.

In all she loaned $430,500 to Brad.

She obtained a written note. It had interest at 5% and matured on December 31, 2007.

How did our tale turn out?

Yep. Our protagonist – the enigmatic, charismatic, problematic Brad – defaulted.

To be fair, he did repay $7,000, so it wasn’t a complete loss.

In 2010 Mary sent an e-mail demanding payment. Brad replied:

"I have no money.”

She continued trying.

In 2011 she filed suit for performance.

In 2012 she received a judgement against Brad.

In 2014 she reasoned that if Brad could get his comic strip syndicated, then he might have enough money to pay her back. She introduced Brad to people. She did not however get any interest, ride or other participation should Brad ever get the comic published.

In 2010 Mary set up an LLC to take-over the note. She then claimed it as a business bad debt on her/their 2010 joint tax return. The note, including interest, was over $600,000 at that time. Not surprisingly, this created a net operating loss, which she carried-back to 2008 for a refund.

We already know that they went to Tax Court.

While there were several issues in the case, we are concerned with only one today 

There are two pieces here:

You made a loan that went south, and

You are in the trade or business of making loans

The IRS quite agreed that Mary made a loan, but they argued that she did not meet the second requirement.

You do not need a building and employees to be in the trade or business of making loans, but you do need to make loans repetitively. That is what “trade or business” means: Jimmy John's does not make one sandwich and call it a day. One loan does not rise to the level of “repetitively.” It also helps to meet the routine requirements that banks and other lenders observe: perform credit checks, obtain financial information, obtain security for the loan, etc.

Mary in turn argued that she worked on content deals all the time at Blockbuster, and Brad’s comic strip was “content” by another name. She was in a “trade or business” because she had done something similar at work.

Not a bad argument, but it had two holes:

Mary did not loan money to Brad in the context of her job at Blockbuster. As a consequence, what she did at Blockbuster was not particularly relevant to the tax outcome of her loan.

Even allowing for that, she did not have an interest, royalty, or other equity participation in the comic strip. She could have demanded it from Brad, but she did not. The only thing she had was a creditor interest, the same as Fifth Third or SunTrust have when they lend money. We are still talking about a loan.

The Court decided that Mary had a nonbusiness bad debt.

The tax difference is huge.

If you have a business bad debt, you can deduct the loan the same way you would deduct your rent, payroll or any other expense. If the sum goes negative, you might have a net operating loss that you can carryback and/or carryforward, offsetting taxable income in other years. If you can carryback, you might even get a refund of taxes previously paid.

If you have a nonbusiness bad debt, the most you can do is offset your capital gains plus $3,000. That’s it. The biggest net subtraction you get can on your tax return is $3 grand. And there is no carryback. Mind you, you can carryforward indefinitely, but at $600 grand Mary would be carrying-forward until the cows came home.

Which is why Mary wanted the business bad debt so badly.

But she was not in the business of making loans. The best she could do was the $3,000. 

She owed the tax. She owed the penalty. It was a loser for her all around.