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 Dear
Tax Talk,
Three years ago I invested $13,000 in my brother's small business.
The company was an S corp. I was not issued shares in exchange
for the money. Three months after the transaction, the company
went bankrupt. Is there any way I can recoup some of my money
as a tax write-off? Can I consider the investment as a capital
loss? If so, what form should I fill out and what documentation
do I need?
-- Paul
 Dear
Paul,
It certainly sounds like you have a tax write-off, but I hope
you haven't written off your brother.
Although a family loan situation is an area
the Internal Revenue Service scrutinizes, if you have adequate
documentation to demonstrate the amount was intended as a
loan and not a gift, you should be able to claim a write-off.
Some of the items the IRS would look at in addition to the
actual canceled check or other conveyance of funds would be:
1. Loan documents -- Was a promissory note prepared?
2. Collection attempts -- Did you send written demands for
payment?
3. Bankruptcy -- If the company formally filed for bankruptcy,
did you present yourself as a creditor?
While the absence of the foregoing does not
mean that your deduction is doomed, it is more susceptible
to IRS attack.
There also is a question as to the timing of the deduction.
You should have claimed the loan as a nonbusiness bad debt
(short-term capital loss on Schedule D) in the year that it
became worthless. If you made the loan three years ago and
the company went under three months later, then you have to
demonstrate that 2004 is the proper year of write-off as opposed
to a year or two earlier.
Perhaps you waited until now as you expected
your brother to make good on the loan. In this case, 2004
may be the proper year of write-off. If not then maybe you
need to think about amending your earlier returns before the
statute of limitations expire. In any event, your capital
loss would be limited to your capital gains plus a $3,000
write-off against other income.
IRS Publication 550 provides the following instructions on
how to claim a nonbusiness bad debt:
How to report bad debts. Deduct nonbusiness bad debts as
short-term capital losses on Schedule D (Form 1040).
On Schedule D, Part I, line 1, enter the name of the debtor
and "statement attached" in column (a). Enter
the amount of the bad debt in parentheses in column (f).
Use a separate line for each bad debt.
For each bad debt, attach a statement to your return that
contains:
1) A description of the debt, including the amount, and
the date it became due,
2) The name of the debtor, and any business or family relationship
between you and the debtor,
3) The efforts you made to collect the debt, and
4) Why you decided the debt was worthless. For example,
you could show that the borrower has declared bankruptcy,
or that legal action to collect would probably not result
in payment of any part of the debt.
Beginning on page 54 of that publication, the IRS provides
a discussion of claiming bad debts that you may want to review.
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Deducting
a family-business debt
