Business Bad Debts
By James T. Connolly, CPA, Partner
Generally bad debts are an unavoidable cost of doing business. The good news is that for tax purposes they provide a deduction to offset income. The bad news is that it is far more complicated than you would think to determine when a debt should be written off.
Internal Revenue Code (IRC) Section 166 allows for the write off of “any debt which becomes worthless within the taxable year,” but unfortunately neither it nor the underlying regulations provide much clarity on when a debt becomes worthless.
In a recent case, Sarvak v. IRS, TC Memo 2018-68, the court settled a difference of opinion between a taxpayer and the Internal Revenue Service (IRS) about when a debt becomes worthless. In this situation, Bradford Sarvak was Emery Financial, Inc’s sole shareholder. The company made 24 advances totaling over $350,000 during 2011 to William Boehringer. At the time of preparation of the company’s 2011 returns, it was determined that the 2011 loans were not collectible and thus were written off.
Upon examination, the IRS determined that the corporation was not entitled to the bad debt deduction, contending that the owner “failed to show that the advances…became worthless during the tax year at issue.” The court cited case law which established five requirements for the taxpayer to deduct a business bad debt:
- Establish the existence of debtor-creditor relationship
- Show that the debt was created in connection with a trade or business
- Show the amount of the debt
- Prove the worthlessness of the debt
- Determine the year that the debt became worthless
In this case, the court ruled that Mr. Sarvak failed to demonstrate that he intended to create a bona fide debtor-creditor relationship since he did not execute any notes, request collateral, provide documents supporting any terms or proof that interest was to be charged.
Even more damaging, the court ruled that Mr. Sarvak did not meet the objective standard by showing an identifiable event that had occurred which gave reasonable basis for abandoning all of recovery. His last advance occurred a mere 10 days prior to December 31, 2011, which is when he purportedly made the determination that the loans were uncollectible. Furthermore, the company made additional advances in early 2012 after the 2011 advances were purportedly worthless, which did not exactly help the taxpayer’s case. Finally, there was no proof provided that the company made any efforts at collection.
What can we learn from this case? While there is no one thing that can be done to assure proper deduction, the following suggestions are helpful in building a more solid case:
- Document – If you make a loan from your business, draft the proper paperwork which establishes the terms of the loan, including a reasonable rate of interest and the terms for repayment.
- Take collateral – If you do not have collateral, it can show that you may not have true intent to collect, and therefore there may not be a bona fide debtor-creditor relationship.
- Pursue collection – You cannot simply make a decision to write off a bad debt because the debtor is having trouble paying. You need to follow up with collection measures up to and including legal action. Be sure to document your collection efforts.
- Seek professional advice – At the end of the day, these determinations are based on facts and circumstances and have an element of subjectivity. It is always best to consult with your tax advisor when making these determinations so that you can be sure all of your bases are covered.
James T. Connolly Tax Partner, CPA
James is a tax partner at our firm with over twenty years of experience in public and private accounting. With a background in auditing and private accounting, James has spent the last thirteen years in the tax world working with small businesses and individuals to meet their tax compliance and consulting needs. While he has clients in […]