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Important FAQ: Section 166

By:
Robert M. Finkel
Published Date:
Oct 1, 2020

These days, many of our clients are holding debt obligations they can’t collect. The IRC may provide some relief, in the form of a tax deduction or loss, for creditors holding a worthless (or in some cases even a partially worthless) bona fide debt, provided that conditions set forth within IRC section 166 and the related Treasury Regulations are satisfied.

What is a “bona fide” debt?

A bona fide debt is one that arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money [Treasury Regulations section 1. 166-1(c)]. A bona fide debt can be created by a commercial transaction, borrowing or by operation of law.

Unpaid amounts arising from wages, salaries, fees, rents, and similar items of taxable income are not deductible, unless the income these items represent has been included in taxpayer’s income. [Treasury Regulations section 1.166-1(e)]. A debt arising out of the receivables of an accrual method taxpayer is deemed to be an enforceable bona fide debt, to the extent that the income such debt represents has been included in income.

Example: L, an accrual basis landlord, has accrued income representing rent payable by T, tenant under the applicable lease for Y1. In Y2, the receivable is determined to be worthless. A deduction is permitted.

A taxpayer claiming a bad debt deduction under IRC section 166 must establish that the advance was originally made with a bona fide expectation that such amount would be repaid. Accordingly, an advance that was intended as a contribution to capital or a gift does not qualify as debt for purposes of IRC section 166.

The question of whether a transaction gives rise to a bona fide loan resulting in a bona fide debt is a factual one, although no consistent set of controlling factors has arisen in the case law.

A bona fide debt may also arise by operation of law.

Example: A, as party to a contract advanced funds to B, who subsequently breaches. As a result of a subsequent rescission, A’s entitlement to recover the advanced amount is a bona fide debt.

If a repayment obligation is subject to a condition precedent, such obligation will not create a bona fide debt for purposes of the bad debt deduction until the condition is satisfied, waived, or excused. Unenforceable loans, such as usurious transactions or others that are void or voidable under state law are not bona fide debts. (Harriman v. Commissioner)., T.C. Memo 1967-190.

Note that under IRC Section 165(e), special rules apply to debts evidenced by a security as defined in IRC section 165(g)(2)(C).

Does it matter whether the debt arose in a business context?

IRC section 166(a) distinguishes between business and nonbusiness bad debts. Business bad debts are deductible to the extent that they have become either partly or wholly worthless, with any unused portion of the deduction carried back and carried forward as a net operating loss to offset ordinary income from other taxable years, pursuant to IRC section 172.

Nonbusiness bad debts can only be deducted by non–C corporation debtors when they are wholly worthless and are treated as a short-term capital loss subject to the limitations of IRC sections 1211 and 1212 in the year in which the debt becomes wholly worthless.

For this purpose, an S corporation that sustains a nonbusiness bad debt determines its taxable income under the rules applicable to noncorporate taxpayers. Therefore, no deduction is permitted to an S corporation on account of a nonbusiness debt becoming partially worthless. If a nonbusiness debt becomes wholly worthless, no ordinary loss deduction is permitted but the S corporation has a short-term capital loss. (Revenue Ruling 93-36, 1993-1 C.B. 14)

A business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to a trade or business when it became either partly to totally worthless. Business debts can include business accounts receivable; business-related loan guarantees; and loans to customers, vendors, and employees.  

In order to be a business bad debt, the loss must bear a “proximate” relationship to the creditor’s trade or business. In determining whether the relation is “proximate,” the dominant motivation for making the loan must have been business-oriented (United States v. Generes). A debt is a business debt if the dominant motive for the loan is to benefit the lender’s trade or business (Syracuse v. Commissioner).

Is payment by a guarantor a “bona fide” debt for this purpose?

The payment by a taxpayer pursuant to an agreement to act as guarantor, endorser, or indemnitor of an obligation is not deductible as a worthless debt unless the agreement was entered into either in the course of the taxpayer’s trade or business or in a transaction engaged in for profit, according to Treasury Regulations sections 1.166-9(a) and (b).

A guarantee agreement is considered to have a profit motive if the guarantor can demonstrate that he received reasonable consideration for giving the guaranty. In certain circumstances, consideration for a guaranty can include indirect business value. Guarantees given in connection with ordinary business practice or for a bona fide business purpose don’t require monetary consideration. Benefit to the business is sufficient. However, in cases of guarantees of loans to a spouse or persons eligible to be claimed as dependents, indirect consideration is not sufficient to support a deduction. [Treasury Regulations section 1.166-9(e)]

Subchapter C Corporations that are guarantors, endorsers, or indemnitors are treated differently than other guarantors, endorsers, or indemnitors for purposes of determining whether a payment qualifies for a business bad debt deduction. If a C corporation agrees to act as a guarantor, endorser, or indemnitor, resulting payments made by it are deemed to be made in connection with the corporation’s trade or business and are deductible, if they otherwise qualify for a bad debt deduction under IRC section 166.

However, taxpayers other than C corporations that enter into guaranty agreements not in the course of their trade or business, even if done for profit, and thereafter satisfies the debt in accordance with the agreement, may only claim a nonbusiness bad debt deduction.

Importantly, any right of subrogation under state law in the guarantor is disregarded in evaluating the deductibility of payment on a guarantee.

When is a debt worthless?

IRC section 166(a)(1) allows a deduction in the taxable year that the debt becomes worthless. Worthlessness is not defined in the statute or the applicable Treasury Regulations. The Treasury Regulations, however, speak to “evidence of worthlessness.” And while the courts have identified no standard test or formula for determining worthlessness within a given taxable year, it’s generally accepted that the year of worthlessness is to be fixed by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery. (Crown v. Commissioner)

Worthlessness is a question of fact requiring consideration of surrounding facts and circumstances, including the debtor’s financial condition and the value of any security. The cases interpreting the Treasury Regulations consider a wide range of facts and circumstances in determining collectability, with at least some courts endeavoring to apply “sound business judgement” in evaluating worthlessness. (Kirksville v. U.S.; Minneapolis, St. Paul & Sault Ste. Marie R.R. Co. v. United States)

Evidence that a debtor is experiencing financial difficulties will not by itself support an argument for worthlessness. Other factors supporting worthlessness include—

  • insolvency;
  • abandonment of business;
  • serious financial reverses;
  • relative security;
  • refusals to pay on demand; and
  • the expiration of the statute of limitations.

A bankruptcy filing, though not determinative, could indicate that an unsecured business debt is at least partially worthless [Treasury Regulations section 1.166-2(c); Bunch v. Commissioner, T.C. Memo 2014-177]. Given the lack of legislative guidance setting forth objective criteria and the wide range of facts and circumstances considered in the many cases considering the issue of worthlessness, a review of cases involving factors similar to the debt in question is recommended before taking a reporting position.

A taxpayer’s mere acceptance in settlement of a debt, less than the full amount due from a debtor, will not alone support worthlessness.

Example: Taxpayer-lender accepts less than the full amount owed by a solvent debtor because he needs cash before the debt is due. The uncollected portion of the debt is not a bad debt.

Generally, a bad debt deduction will not be allowed to a taxpayer who has made no request for payment or attempt to collect the debt (Franklin v. Commissioner). Nevertheless, some courts have ruled that a bad debt deduction isn’t barred by the fact that the taxpayer never made a formal demand for payment where the debtor was clearly unable to pay, such that the demand for payment would’ve been a useless act.

Legal action to enforce a debt may be helpful in demonstrating worthlessness; though it’s not required where surrounding circumstances indicate that legal action to enforce payment would in all probability not result in collection of the amounts owed, the taxpayer isn’t required to take legal action to collect the debt. [Treasury Regulations section 1.166-2(b); Carroll v. Commissioner]

When is a debt “partially worthless”?

Unlike nonbusiness debts, which may be deducted only when wholly worthless, business debts may be deducted when partially worthless. If the taxpayer demonstrates that she can recover only part of a business debt, she may deduct the worthless portion, provided that it is “charged off” within the taxable year. [IRC section 166(a)(2); Treasury Regulations section 1.166-3(a)(2)]

A deduction for a partially worthless business debt may be claimed either in the year in which the portion of the debt becomes worthless, in a subsequent year, or in the year that the debt becomes wholly worthless.

For this purpose, a debt is charged off the debtor’s books and records when it no longer appears to be an asset of the debtor’s business. Whether there has been an effective charge off is essentially a question of fact. As a practical matter, courts have liberally interpreted the requirement that a charge off be made “within the taxable year” to reflect business practicalities when the entry is made after the close of the year, consistent with past practice, while the books for the year are still open, if it it’s dated no later than the last day of the taxable year.

Note that no charge off is required where a debt is wholly worthless. If, however, the debt is deducted as worthless and no charge off is made, and there’s a later determination that the debt was only partially worthless, no deduction is allowed. Accordingly, the IRS suggests that taxpayers may want to consider charging off both totally and partially worthless business debts.

Whether a particular taxpayer has provided sufficient facts to support a deduction for a partially worthless bad debt is a determination subject to the discretion of the Commissioner. Unless an abuse of discretion is shown, the courts will typically uphold determinations made by the Commissioner that sufficient facts haven’t been shown to justify a partial bad debt deduction.

Note that no deduction for partial worthlessness is permitted with respect to “securities,” which includes bonds, debentures, notes or certificates, or other evidence of indebtedness issued by a corporation or by a governmental or political subdivision thereof, with interest coupons or in registered form.

How much is deductible?

Bad debts arising in connection with business transactions are generally deductible in full to the extent of the creditors’ basis in the debt, per IRC section 166(b). A taxpayer’s basis may not be the same as the face value of the instrument, according to Treasury Regulations section 1.166-1(d)(s)(i)(b).

Example: Where taxpayer creditor purchased a $100K note for $80K, his basis is cost, not its face value.

A taxpayer’s basis is reduced by payments received on the debt. Payments made in the form of property reduce the basis of the debt by the fair market value of the property received. Basis is also reduced for prior deductions taken with respect to partial worthlessness.

Importantly, the deduction for nonbusiness bad debts is limited by IRC section 166(d), which treats them short-term capital losses, subject to the limitations of IRC sections 1211 and 1212.

When is the deduction allowable?

A deduction is allowed for debts that becomeworthless (or partially worthless in the case of business bad debts) “within the taxable year.” This, of course, makes the timing of the determination of “worthlessness” critical. Indeed, taxpayers need establish not only that the debt was worthless by the end of the year in which the deduction was claimed, but also that the debt wasn’t worthless at the end of some preceding year.

Where it is determined that the loss was properly allowable in an earlier year, a claim for refund might be allowed under IRC section 6511(d)(1), which lengthens the period for claiming a refund arising from a bad debt deduction from three to seven years. Nevertheless, it’s generally advisable to take the deduction in the earliest year in which there are reasonable grounds for believing the debt is worthless.

Who has the burden of proof?

The burden of proof to show worthlessness and the timing of worthlessness is on the taxpayer claiming a deduction. All pertinent evidence should be considered, including the value of any collateral and the financial condition of the debtor [Treasury Regulations section 1.166-2(a)]. A statement of facts substantiating any deduction claimed under IRC section 166 on account of bad debts must be attached to the tax return [Treasury Regulations section 1.166-1(b)(1)].

The IRS suggests that the statement attached to a return claiming a nonbusiness bad debt include a description of the debt, including—

  • the amount, and the date it became due;
  • the name of the debtor and his business or family relationship, if any, to the taxpayer; and
  • the efforts the taxpayer made to collect the debt.

What happens if I later collect on my worthless bad debt?

In general, amounts recovered on a bad debt for which the taxpayer had taken a deduction will ordinarily be included in gross income in the year received, except that gross income does not include such income if the amount deducted in any prior taxable year did not reduce the amount of tax otherwise imposed.

Takeaway

Tax relief for both business and nonbusiness bad debts may be available; but a keen focus on the surrounding facts and timing is critical.


Robert M. Finkel is the partner-in-charge of Moritt, Hock and Hamroff, LLP’s New York City office where he also serves as co-chair of its tax practice group. Mr. Finkel has been an adjunct professor at Boston University School of Law’s Graduate Tax Program since 1995. He was an adjunct professor at the Radzyner Law School (IDC Herzliya, Israel) where he taught U.S. corporate and tax law (2005-2006).

 
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