Category: Deductions & Credits; Individuals
Subject: Bad Debt
Title: Business Bad Debt: Loan to Employer Corporation
IRC Sections: 166(d)(2)
Filename: 1104.html
Date Produced: 3/97

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer (TP) is the sole shareholder of a professional corporation (PC) engaged in providing engineering services. Over the past few years, TP has loaned the corporation approximately $150,000 evidenced by a series of interest bearing notes. TP retired from a career in the military. When TP joined PC, there was another shareholder and PC was a profitable firm. TP ultimately bought out the other shareholder, and PC's profitability began to decline.

TP is now 66 years of age. TP has now decided to discontinue the business and wishes to take a business bad debt deduction for the amount loaned to PC.

Discussion
Whether a debt is business or nonbusiness is a mixed question of fact and law. The taxpayer bears the burden of proving that his facts are such that the bad debt meets the definition of a business bad debt for tax purposes.

Section 166(d)(2) and Regs. Section 1.166-5(b) define a nonbusiness bad debt by a process of exclusion, that is, a debt other than:

(A) one created or acquired in connection with the taxpayer-creditor's trade or business; or

(B) the loss from the worthlessness of which was incurred during the operation of the taxpayer-creditor's trade or business.

In order to qualify as a business bad debt under the first rule of exclusion, the worthless debt must have been created or acquired in the particular taxpayer's trade or business.

A variety of taxpayers have succeeded in getting business bad debt treatment by proving that their dominant motive for lending money was to secure or maintain an employment relationship. Because being an employee is considered a trade or business, a proximate relationship between a loan gone bad and the taxpayer's employment has in some cases yielded a business bad debt deduction.

As part of this analysis, it is essential to keep in mind that the employment relationship must be the taxpayer's dominant motivation for making the loan. It is not sufficient that considerations of the taxpayer's employment were merely important to the decision to make the loan. See U.S. v. Generes, 405 U.S. 93 (1972).

The following cases seem particularly interesting given the taxpayer's fact pattern.

In Litwin v. U.S., 91-1 USTC Para.50,229 (D. Kan. 1991), aff'd, 983 F.2d 997 (10th Cir. 1993), the district court found that the loans and guarantees made by an 83-year-old shareholder outstripped his expected annual salary and exceeded his financial risk by more than three times. Therefore, the court held that the taxpayer had not willingly risked these funds for an anticipated return on investment; instead, the court found that all of his actions evidenced a desire to continue to use his managerial skills to run the business. In other words, the taxpayer made the loans and guarantees because he wanted to be actively employed in responsible positions and to enjoy the rewards of his work (i.e., salary and personal achievement). On appeal, the Tenth Circuit affirmed the district court in Litwin, concluding that the district court had before it substantial evidence of the taxpayer's business purpose in making the loans and guarantees.

In Jaffe v. Comr., T.C. Memo 1967-215, T.C. Memo 1967-215, worthless loans by two employees who owned all the stock of the corporation were deductible as business bad debts, because the loans were made in order to protect their jobs. One employee was 70 years old and would have been unemployable if he had lost his job with the debtor.

In Carter v. Comr., T.C. Memo 1979-447, the taxpayer was found to have lent money to his controlled corporation to protect his employment where the corporation had incurred substantial losses and very likely had little value as an investment.

In Fitzpatrick v. Comr., T.C. Memo 1967-1, the taxpayer prevailed because he showed that at age 65, he would have had difficulty finding other employment at another company, and thus his dominant motivation for the loan was to protect the employment arrangement he already had.

In Avery Est. v. Comr., T.C. Memo 1969-64, the taxpayer prevailed where he formed the debtor corporation as a means of exploiting his own talents. The decisive factor was that his personality prevented him from working under any other arrangement.

In Pierce v. Comr., T.C. Memo 1986-552, the taxpayer established that the loan in question was with a view toward prospective employment.