NONBUSINESS VS. BUSINESS BAD DEBT

Individuals who are stockholders or employees of a corporation often lend it funds. When the loan turns sour and does not get repaid, a "business" bad debt deduction, if allowed, allows for an ordinary loss. However, if the loan is a "nonbusiness" bad debt, the lender only receives short-term capital loss treatment. Further, for nonbusiness bad debts, a deduction is allowed only if the debt is wholly worthless - business bad debts are allowed for partial worthlessness.

If the lender is an employee of the corporation and that employment is the lender's primary employment, the taxpayer can often make a reasonable showing that he or she made the loan to protect his trade or business as an employee (and not just as an investment). In that situation, business bad debt treatment should be available. That is, if the lender believed the corporation needed the loan to keep the lender's job going, that should be enough.

Problems arise when the lender's motivation relates more to the investment side of things, and not protection of his or her employment. This tends to come up more when the lender is both an employee and a stockholder. As such a lender in a recent Tax Court case learned, this opens the door to a strong argument that the loan was made more to protect the lender's investment in the company than his or her employment. There, the taxpayer lost his bid for business bad debt treatment. In finding that the loan was a nonbusiness bad debt instead, it noted:

[T]he dominant motivation for making the loans was not petitioner's trade or business as an employee of the companies. ... Petitioner designed the software used by the companies and invested a significant amount of time and money to ensure the success of the companies. Protection of petitioner's investment interests in the companies, rather than protection of his salary, was the dominant motivation for the loans.

What was especially problematic for the taxpayer was that in the year after the loan was made, the lender did not receive any pay from the two companies involved. While not explicitly discussed, the Court's mentioning of this fact presumably helped it reach the conclusion that the loan was not made principally for employment purposes. Whether it would have ruled for the taxpayer if the lender continued to receive compensation is unknown.

Harry R. Haury, TC Memo 2012-215