Lessons from the Tax Court: Bad business debt wasn’t legit

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in Small Business Tax,Small Business Tax Deduction Strategies

A taxpayer can claim deductions for bad debts that can’t be collected and become worthless. But the IRS often regards such deductions with a healthy dose of skepticism when transactions involve related parties, such as a purported loan from a business owner to his or her corporation.

This type of arrangement proved to be the undoing of a taxpayer in a new Tax Court decision.

Facts of the case: SRG Corp. was owned by June Shaw, her mother and her siblings. Shaw also was employed at SRG as an officer. Early in 2009, she agreed to commit $1 million, in the form of a revolving line of credit, to fund a development project for SRG. The note from SRG Corp. called for 10% annual interest, which was to accrue until 2011, when the principal was also due. Shaw didn’t require any collateral and the line of credit was unsecured at all times.

Shaw began making advances shortly after the note was signed. At that time, SRG Corp. was encountering financial difficulties, which only worsened toward the latter part of the year. Nevertheless, Shaw continued to transfer funds to SRG Corp. throughout 2009 under the line of credit.

Ultimately, the advances by Shaw for 2009 totaled $800,000. But the development project was never completed and it was formally “canceled” at the end of the year. No interest or principal was ever paid on the note.

Shaw claimed that she demanded a repayment of $5,000 at the end of 2009. However, she didn’t launch any legal action in an effort to secure repayment or obtain a professional opinion from an accountant or a financial consultant that the note was worthless. On her 2009 tax return, Shaw claimed a bad debt deduction for the entire $800,000.

The Tax Court said Shaw didn’t have a leg to stand on. Reasons: She failed to show that the advances constituted bona fide loans, nor did she show that any debts were worthless. Therefore, the Tax Court turned down the deduction. (Shaw TC Memo 2013-170)

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