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

If you own a small business and made a loan to a company or individual and they can’t pay you back, you may be able to write off the loss. Depending on the type of business you have, as well as the details of the loan, you could take a write off for the loan as a bad debt deduction. But to write off a loan to someone, you must be able to show there was a real debt. Capital loans to your business are considered part of your ownership and cannot be deducted. Business bad debts are usually deductible ordinary losses.

Bona Fide Debt

Only bona fide debts are eligible for the bad debt deduction. A bona fide debt exists when a debtor-creditor relationship is created in which a party owes something to another party. To get a bad debt deduction, the borrower must have a valid, enforceable obligation to repay a fixed or determinable amount. Simply calling money given to another person or business a loan doesn’t automatically guarantee the tax benefits you’re looking for. It’s easy to confuse this type of loss with gifts, which are not deductible. The IRS can be cautious with “loans” made between related parties. You need to be able to show there was real intent and genuine expectations involved.

There is a complex body of case law on this issue that makes the test fact intensive. Often the courts give more weight to a loan with loan terms such as a maturity date, interest payment schedule, fixed interest rate, and proof of good faith, like a personal guarantee. Actual interest payment, any security pledged as collateral, and actual repayment of a loan also help prove your business debt is a real debt.

If you put money into your business so it can make a big purchase, you are at risk of having your debt classified as equity, especially if the investment you make is in proportion to the ownership percentages. You run into this problem if the money has no security for a guarantee, the money is behind other debt and unsecured, or you use the money to buy long-term assets.

Whether the Bad Debt Is Business or Nonbusiness

Only business debts can be deducted as ordinary losses. Nonbusiness bad debts must be deducted as short term capital losses. Capital losses can only offset capital gains. Only $3,000, $1,500 if married filing separately, in capital losses beyond any capital gains can be deducted from ordinary income in any one year. Nonbusiness bad debts are deductible only when entirely worthless. So whether the bad debt is business or nonbusiness is a critical question.

A good question to ask is if you’re in the business of making loans. However, you can have a proximate relationship between your loan and a way you earn your livelihood. Your business reason needs to be compelling in order to nail this one. The Supreme Court in the Generes case indicated that the dominant motive test must be business-related and that a “significant” motive was insufficient to approve the deduction. If you intend to protect your job but you’re also doing it to protect your investment, it’s much less clear. It’s a fact-intensive question often determined on a case by case basis. It’s easier to pass the business related test if you loan the money to a key vendor or customer as a sole proprietor.

A bad debt deduction is not allowed until the year the debt actually becomes worthless. But you don’t have to wait until a loan is due to deduct it. If there is still a reasonable chance it can be collected, it is not yet worthless. Just as in the case of deciding whether the loan is business-related, the determination of when the loan became worthless is a fact-based question. In the case of a business debt, you can take a partial worthless debt deduction. You can add to the evidence in favor of writing off a loan by showing you took reasonable collection steps. One such step is initiating legal action to recover the funds, but you don’t have to. What you’re trying to demonstrate is that you pursued a reasonable process of attempting to collect, but couldn’t. It can be hard to pin down exactly when a debt became worthless, so you can generally amend your return for up to seven years.

If you personally guarantee your company’s loan, repayment can be a tough call. Since a shareholder guaranteeing a loan on company debt protects the shareholder’s investment in the company, and therefore does not rise to the level of a business motivation, there is no business debt, only a nonbusiness one. However, if your primary intent is to protect your job, courts may approve the repayment as a business debt. If you act only as a pure favor, it’s a gift with no deduction. Don’t be too hasty on writing off the loan, either. If your company still has assets, you might be able to recover at least some of the loss.

Where It’s Reported

Whether the loss is business or nonbusiness impacts where it’s reported. Business deductions go on Schedule C or business return for partnerships and corporations. Nonbusiness deductions go on Form 8949, part I with a statement stating facts and circumstances, the type of debt, your relationship with the debtor, your efforts to collect the debt, and the reason why it is worthless.

To back up your deduction, show that the funds advanced were a loan and that it is a legitimate debt owed you. Provide any repayment schedules or record of actual repayments. Provide any contracts for the loan, bills, or other documentation showing the debt exists. If your loan, particularly the one between you and a family member, doesn’t appear at arm’s length or bona fide, you run the risk of an IRS challenge. Make sure you’re prepared to defend your deduction. Putting all the pieces together can be tricky in some cases, so consider getting advice from a business attorney, CPA or tax professional before filing your return.