Bad Debt Deduction for Advances to a Family Company

Posted by: DeAnna Alger

The IRS has implemented stringent guidelines that must be followed in order for an individual to be able to take a bad debt deduction for advances made, especially when made to a family corporation.  The taxpayer must be able to demonstrate that the following factors existed. 

1. The loan must be bona fide debt.  To be considered bona fide debt, there has to be a debtor-creditor relationship and a valid, enforceable, and unconditional obligation for repayment.  It is important for the creditor to have documentary evidence of the debtor’s creditworthiness.
2. A valid debtor-creditor relationship must have existed when the debt came into effect.
3. The debt became worthless in the tax year in which the taxpayer wishes to take the bad debt deduction.  Debt can be considered worthless and uncollectible when legal action to enforce payment would in all probability not result in repayment, the taxpayer has made a reasonable effort to collect the debt, and there is no reasonable possibility that the debt may be collected in the future.  Examples of possible situations include bankruptcy of a debtor, termination of the debtor’s business, the debtor dies, and a significant drop in the value of property that is securing the debt.

When the debtor-creditor relationship involves family members or a family business, the IRS will look carefully at the money loaned to make sure that it was intended to create a debt.  Since the IRS often looks at such loans as equity capital advances, instead of loans, it is critical to have proper documentation showing the amount of the loan and the terms and conditions for repayment, including a reasonable interest payment.

As with all other tax deductions, the IRS has strict rules surrounding bad debt deduction substantiation. If you have questions or concerns about whether or not you have the proper support to back up your deduction, please give the professionals at Zinner & Co. a call.