Claiming Bad Debt Loss Deductions: What You Need to Know

When it comes to deducting bad debt losses, individual taxpayers often find themselves at odds with the IRS. To help you navigate this process and get the best possible tax results, here’s a breakdown of the key rules and strategies for claiming bad debt deductions.

Basic Guidelines for Deducting Bad Debts

To qualify for a bad debt deduction, you must prove that the loss came from a legitimate loan transaction. It’s essential to differentiate between a bad debt and an investment gone wrong. For instance, you can’t claim a deduction for a failed business capital contribution or an informal loan to a friend or family member that wasn’t repaid and instead became an unintended gift.

Once you’ve established that a genuine debt exists and has become worthless, the next step is determining whether the loan is a business loan or a nonbusiness loan. This distinction has significant tax implications.

Business vs. Nonbusiness Bad Debts

Business Bad Debts:
For tax purposes, business bad debt losses are treated as ordinary losses. This means you can generally deduct them in full without limitation. Even partial business loan defaults may qualify for deductions.

Nonbusiness Bad Debts:
Nonbusiness bad debts are subject to less favorable tax treatment. If a debt is classified as nonbusiness, it’s treated as a short-term capital loss (STCL). The IRS limits the deduction of STCLs to $3,000 per year ($1,500 for married individuals filing separately). Unlike business debts, you cannot deduct losses from partially worthless nonbusiness bad debts.

A specific gray area arises when the bad debt loss is from loans made by employees to their employers. These types of losses receive even less favorable treatment than nonbusiness bad debts (see “Losses from Loans to Employers” section below).

Losses from Loans to Employers

If you lend money to your employer and it results in a bad debt, the IRS generally classifies it as an unreimbursed employee business expense. Prior to the Tax Cuts and Jobs Act (TCJA), you could write off such expenses if they exceeded 2% of your adjusted gross income. However, since TCJA suspended deductions for miscellaneous expenses between 2018 and 2025, losses from loans to employers are no longer deductible. It’s unclear whether this provision will be extended beyond 2025.

Proving the Existence of a Bona Fide Debt

The first step in claiming a deductible bad debt loss is proving that the debt is legitimate. A helpful case from the U.S. Court of Appeals for the Sixth Circuit (Indmar Products Co., Inc. v. Commissioner, 444 F.3d 771, 6th Cir. 2006) offers some guidance. The court ruled that cash advances from shareholders to their closely held corporations were loans rather than equity investments, considering the following 10 factors:

1. Loan Documentation
   The stronger your documentation—such as showing the loan on both the borrower’s and lender’s financial records—the more likely the debt will be considered legitimate.

2. Maturity Date and Repayment Schedule
   A formal loan agreement with a fixed repayment schedule is a strong indicator that the debt is valid. Additionally, past repayments can help confirm the legitimacy of the loan.

3. Interest Rate and Payments
   Charging interest and making regular interest payments are important factors in proving that a cash advance is a loan.

4. Source of Repayment Funds
   If repayment relies on the borrower’s profits, it’s more likely to be seen as an investment than a loan. However, this is often the case even with legitimate loans.

5. Debt-to-Equity Ratio
   A high debt-to-equity ratio in a corporation can suggest the cash advance is an equity investment. This is less of a concern if the corporation has a track record of repaying debt.

6. Overlap Between Shareholders and Lenders
   If shareholders make loans in proportion to their stock ownership, this may indicate an equity investment rather than a loan.

7. Security
   A loan made without collateral or a personal guarantee is typically seen as an equity investment.

8. Availability of Outside Debt Sources
   If the borrower could have obtained third-party debt financing, the loan is more likely to be considered legitimate.

9. Subordination
   Loans that are subordinate to all third-party debt are often treated as equity investments.

10. Use of Proceeds
    Loans used for working capital generally indicate a legitimate loan, while funds used to buy long-term assets may be seen as an equity investment.

These factors can also be applied to assess other types of cash advances and determine the correct tax treatment.

Determining Business Bad Debt Losses

Once you establish that the debt is legitimate, the next step is to determine whether it qualifies as a business or nonbusiness bad debt. If you’re in the business of lending money, this distinction is straightforward. If not, the decision can be more challenging.

According to the IRS, there must be a “proximate relationship” between your business and the loan for it to qualify as a business bad debt. In the case of United States v. Generes (405 U.S. 93, 1972), the U.S. Supreme Court ruled that the loan must have a dominant business motivation. Merely having a significant business motivation isn’t enough.

It’s easier to pass the proximate-relationship test if the loan is made to support your own business. For example, a sole proprietor might pass the test if they lend money to a key vendor or customer.

Important: In many cases, debts that don’t qualify as business bad debts will be classified as nonbusiness bad debts, which are subject to the $3,000 STCL limit.

Supporting Your Bad Debt Claims

The IRS closely scrutinizes bad debt loss deductions. If you believe you have a legitimate bad debt loss for your upcoming tax return or a previous year’s amended return, it’s essential to work with a tax advisor to prepare the necessary documentation. Keeping detailed records is crucial, especially for bad debts stemming from loans to friends and family.

Need Help with Bad Debt Deductions?

If you’re unsure about claiming bad debt losses or need assistance navigating your tax situation, feel free to reach out to us. Our experienced team is here to help you make the most of your tax deductions.

Call us today at 323-902-1000, email dmitriy@losangelescpa.org, or visit our website at www.losangelescpa.org to get started!