taxes

How to write off an unpaid business loan

George SaenzQuestionDear Tax Talk,
We loaned a startup corporation $25,000 in the form of a promissory note two years ago. It has not been able to repay the business loan and it does not look as though it has the potential to do so.

The note could have been converted to stock upon repayment at a reduced price, so in essence, it is just a loan that for now they are carrying as a debt owed by them to us.

There are no funds to pursue in this company, so litigation is not really an option. How can I write off the loss in my personal taxes? They are willing to provide any paperwork or forms needed -- but we don't know what they are.

Thanks for your time and assistance.
-- John

AnswerDear John,
While you may get a tax write-off, it won't make up for the money that you're out of pocket.

When you genuinely lend someone money that isn't repaid, you have a bad debt. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money. When a bank lends you money, it is pretty much clear that the debt is genuine. You sign a bunch of papers and when you don't pay, the phone calls and collection letters start. A question of genuineness arises when the loan is made to family members without regard to repayment capacity.

In your case, the loan was made to a corporation and put in writing with a convertibility factor. On the surface, it would appear your business loan passes the genuine test.

To sustain the deduction for the bad debt, the IRS would like to see some collection efforts such as the dunning letters or other communication to collect. An exchange of e-mails would be nice evidence to support your claim.

Since you're not in the business of being a lender, your bad debt is considered a short-term capital loss. You can use the loss to offset any capital gains you have in the year that the debt became worthless. If your loss exceeds your gain, you get the standard $3,000 deduction against noncapital gain income. Any unused loss carries forward as short-term capital loss.

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).

For each bad debt, attach a statement to your return that contains:

  • A description of the debt, including the amount and the date it became due.
  • The name of the debtor, and any business or family relationship between you and the debtor.
  • The efforts you made to collect the debt.
  • 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.

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To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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