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.
