When is Bad Debt Deductible?
From time to time a business owner is faced with the problem of a “bad debt”. The issue may ultimately be whether or not that debt is deductible as a business bad debt deduction. The deductibility of bad debt is determined by Internal Revenue Code section 166. Under the provisions of this section, to be able to claim the deduction the creditor must be able to show that the account, note, etc. was a bona fide debt that became wholly worthless in the year in which the creditor wishes to claim the deduction.
Earlier in 2013, the Tax Court dealt with the issue of bad debt deduction based on a note satisfied the requirements of Section 166 (see T.C. Memo. 2013-98). The Court stated that a bona fide debt can only arise from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money. There are many factors that a court may consider in determining the existence of that relationship. Some of these are (1) the names given to the instrument evidencing indebtedness; (2) the presence or absence of a maturity date; (3) the right to enforce the payment of principal and interest; and, (4) the intent of the parties. No single factor is determinative. Whether a purported debt is a bona fide debt for tax purposes is dependant on the facts and circumstances of each case. In the particular case, the Court determined that the note was a bona fide debt.
After determining that the debt was a bona fide debt, the Court turned its attention to the second requirement that must be satisfied for a taxpayer to deduct a bad debt. As previously noted, the second test is whether the debt became worthless in the year the creditor wishes to claim the deduction. In analyzing whether the taxpayer’s debt became worthless in the year deducted, the Court noted that there is no standard test or formula for determine worthlessness. That determination will always depend on the facts and circumstances. The fact that the note has not matured or that no payment under the note is due when the taxpayer claims the bad debt deduction does not necessarily prevent the allowance of the deduction. However, the taxpayer will usually need to show some identifiable events to prove worthlessness in the year claimed. Some of those factors are objective and include the debtor’s serious financial reverses; insolvency of the debtor; the debtor’s earning capacity; the debtor’s refusal to pay; actions the creditor took to pursue collection; subsequent dealings between the parties; and a decline in the value of the debtor’s assets.
The Court stated that none of these identifiable factors are conclusive in and off itself. The fact that the obligation has been difficult to collect, or the debtor’s business is on the decline, or that the debtor’s business has failed to turn a profit does not necessarily justify treating the debt as worthless. Ultimately, the Court ruled that the taxpayer had not presented sufficient evidence that the debt had become worthless and, therefore, the taxpayer was not entitled to a deduction for the bad debt.
Taxpayers need to be aware that if a deduction claimed under Section 166 is later disallowed, the taxpayer would be liable for the tax on the disallowed deduction and possible penalties if it is determined that the taxpayer substantially understated his tax liability.
