Can You Write Off a Loan to a Business? 6 Rules for a Bad Debt Deduction

A loan to a business can be written off, though the Internal Revenue Code interrogates the loan before it allows the loss, and most people who advanced money to a friend's company, or to their own, fail one of its questions without knowing it was asked.

The questions come from section 166 of the Code, its regulations, and one Supreme Court decision from 1972. They concern what the money was when it left the lender's account, why the lender parted with it, and when, precisely, it stopped being collectible. Six rules follow from them.

1. The Advance Must Have Been a Debt on the Day It Was Made

The regulations begin with a condition that sounds obvious and disqualifies a great many advances. Under Treasury Regulation 1.166-1(c), only a bona fide debt qualifies, meaning a debt that arises from a debtor and creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. The same paragraph adds that a gift or contribution to capital shall not be considered a debt.

The IRS applies the gift rule to the most common case directly. A loan to a relative or friend made with the understanding that it may not be repaid is a gift, and a gift cannot become a bad debt deduction by failing to come back. Intent is judged at the start.

The capital contribution rule reaches the owner who funds a struggling company from personal savings. Money put into a business in exchange for, or in support of, an ownership stake is equity, and equity that is lost is a different kind of loss, governed by different sections, with its own limits.

The documents that separate a loan from those alternatives are the ones a bank would have insisted upon: a signed note, a stated principal, a repayment date, some interest, and a record of payments actually made and actually demanded. A lender who has none of these may still have made a loan. The lender will have fewer ways to prove it, and the burden of proof on a deduction sits with the taxpayer.

2. Business or Nonbusiness Decides Which Kind of Loss It Becomes

Section 166 sorts bad debts into two classes, and for individuals the difference is large. Under 26 U.S.C. 166(d), a taxpayer other than a corporation treats a worthless nonbusiness debt as a loss from the sale or exchange of a capital asset held for not more than one year: a short term capital loss. A nonbusiness debt is any debt other than one created or acquired in connection with the taxpayer's trade or business, or one whose loss is incurred in that trade or business.

A short term capital loss offsets capital gains in full, but under section 1211(b) an individual may deduct only $3,000 of net capital loss against other income in a year ($1,500 for a married person filing separately). A business bad debt is deducted against ordinary income without that ceiling. On a hypothetical $60,000 loan and a year without capital gains, the classification is the difference between deducting $60,000 against ordinary income and deducting $3,000.

Corporations stand outside the split. The nonbusiness rule in section 166(d) applies only to taxpayers other than corporations.

3. An Owner's Loan to the Owner's Company Is Judged by Its Dominant Motive

The hardest cases involve the shareholder who is also an employee, who lends the company money or guarantees its bank line, and who can plausibly say that the advance protected both an investment and a salary. The Supreme Court resolved which motive controls in United States v. Generes, decided February 23, 1972. The proper measure, the Court held, is that of dominant motivation, and only significant motivation is not sufficient.

The consequence is that the lender must show the business reason, protecting the job, outweighed the investment reason, protecting the stock. An owner drawing a modest salary from a company in which the owner holds a large equity stake will find that comparison difficult, because the numbers themselves suggest which interest the loan was protecting, and the Court in Generes expressly declined to treat a significant business motive as enough. The rule was announced on one employee's facts and binds every owner who stands in a comparable position, which is a reminder (one the drafters of the regulations did not need, having written the gift and capital rules in the same paragraph) that the Code classifies the lender's reason for the loan and not the loan's paperwork alone. The paperwork is still evidence. It is just not the whole case, and the question of what the owner was protecting tends to be answered by what the owner stood to lose.

Whether a court weighing those interests today would find the balance in a given owner's favor is something no general rule settles, and the answer is written, if anywhere, in the owner's own tax returns and payroll records for the years around the loan.

4. Worthlessness Belongs to One Year, and the Lender Must Identify It

A bad debt is deducted in the year it becomes worthless, not the year the lender gives up hope, and not the year the lender's accountant finds it convenient. The IRS describes a debt as worthless when the surrounding facts and circumstances indicate there is no reasonable expectation it will be repaid, and it expects the lender to show reasonable steps to collect.

Litigation is not required in every case. Regulation 1.166-2(b) accepts, as sufficient evidence, a showing that the debt is worthless and uncollectible and that legal action would in all probability not result in satisfaction of a judgment. Regulation 1.166-2(a) directs attention to the value of any collateral and the financial condition of the debtor.

Because the year is so often misjudged, section 6511(d)(1) allows a refund claim based on a worthless debt to be filed within seven years from the return's due date, rather than the ordinary three. That is, if we are being exact, a longer window to correct the year, not a longer window to choose it.

5. Partial Worthlessness Is Allowed Only for Business Debts

Section 166(a)(2) permits a deduction for a debt recoverable only in part, up to the amount charged off within the year. The IRS limits that relief to business bad debts. A nonbusiness bad debt must be totally worthless before anything is deducted.

The lender whose borrower is paying ten cents on the dollar waits.

6. The Return Has to Tell the Story of the Loan

A nonbusiness bad debt is reported on Form 8949, and the IRS asks for a statement identifying the debtor, the amount and due date of the debt, the efforts made to collect it, and why the lender concluded it was worthless. A business bad debt goes on the business return. For a loan made in cash, the deduction is measured by the lender's basis, which the regulations tie to the ordinary rules for losses on property. For an unpaid invoice, the amount must have been included in income first, as the IRS explains in Tax Topic 453, so a cash method seller has nothing to deduct.

Each item in that statement is a document the lender either kept or did not.

When the Borrower Is Your Own Company

Owners who lend to their own businesses usually do it when outside money has become expensive or unavailable, and the company that needed the owner's loan has often also taken merchant cash advances debited from its receipts each day. The owner's loan, and any hope of deducting it, depends on the company surviving those obligations or failing in a way the owner can document.

Delancey Street reviews those advance obligations for businesses, without charge and in confidence. Its work is negotiation; it is not a law firm or a tax adviser, so the deduction questions above belong with a CPA or tax counsel, and legal matters go to independently licensed attorneys. The loan the owner made is recorded on one ledger and the advances on another. The owner signs both.