Shareholders or employees of a corporation often lend it funds – expecting to be repaid.
If the loan does not get repaid, a bad debt deduction can be claimed. However, the tax treatment is different for “business” bad debts and “nonbusiness” bad debts.
A business bad debt results in an ordinary loss. A nonbusiness bad debt is treated as a short-term capital loss. In addition, for nonbusiness bad debts, a deduction is allowed only if the debt is wholly worthless, while a business bad debt loss is allowed for partial worthlessness.
If you lend money to a corporation that provides your primary means of employment, you may be able to show that the main purpose of the loan is to protect your trade or business as an employee. In that situation, business bad debt treatment should be available.
But if your primary motivation for the loan is more as an investment in the corporation, nonbusiness bad debt treatment is the result.
If you are both a shareholder in the corporation and an employee, the primary motive for making the loan may be difficult to prove. This difficulty was highlighted in a recent Tax Court case (Harry R. Haury v. Commissioner, TC Memo 2012-215, July 30, 2012).
Harry Haury was a software engineer who developed software and licensed it to NuParadigm Government Systems, Inc. and NPS Systems, Inc. Haury owned 48.3 percent of NuParadigm and 49.2 percent of NPS. He received compensation from NuParadigm but not from NPS.
To reduce cash-flow problems, Haury lent the companies almost $435,000 and claimed a business bad debt deduction when the loans were not repaid. Although the court agreed that the loans were worthless, it concluded:
The dominant motivation for making the loans was not petitioner’s trade or business as an employee of the companies. … Petitioner designed the software used by the companies and invested a significant amount of time and money to ensure the success of the companies. Protection of petitioner’s investment interests in the companies, rather than protection of his salary, was the dominant motivation for the loans.
When lending money to any business in which you are involved, you should be sure to document both the terms of the loan and the reasons for making the loan.