Structuring Intrafamily Advances to Permit Bad Debt Deductions

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

This case study has been adapted from Guide to Tax Planning for High Income Individuals, 6th Edition, by Anthony J. DeChellis and Patrick L. Young, by Practitioners Publishing Company, Fort Worth, TX, 2005 ((800) 323-8724; ppc.thomson.com).

Sec. 166(d) provides that noncorporate taxpayers can claim short-term capital losses for nonbusiness bad debts. These are bad debts that do not qualify as business debts (i.e., debts not created or acquired in the ordinary course of a taxpayer’s business or incurred in the taxpayer’s business). To claim a nonbusiness bad debt deduction, the debt must be totally worthless; a partially worthless debt cannot be deducted.

It is not unusual for taxpayers to loan money to other family members or guarantee their debts. Although Sec. 166 does not bar taxpayers from claiming bad debt deductions in these situations, they are generally subject to close scrutiny; see Caligiuri, 549 F2d 1155 (8th Cir. 1977). Transfers between family members are generally presumed to be gifts, unless the taxpayers prove that a bona fide debt exists; see Perry, 92 TC 470 (1990), aff’d, 912 F2d 1466 (5th Cir. 1990), cert. den., and Vinikoor, TC Memo 1998-152.

Intrafamily Loans

If a bona fide loan exists between family members, the lender can claim a bad debt deduction if the borrower defaults and the lender makes demands for payment. To qualify as a loan, an advance must be made with a reasonable expectation that it will be repaid and that payment is not contingent on the occurrence of some future event; see Zimmerman, 318 F2d 611 (9th Cir. 1963).

Taxpayers making intrafamily loans can better their chances of later claiming a bad debt deduction if they follow certain formalities when the loan is made. The more the loan attributes equate with standard commercial terms (including the borrower’s responsibility for the reasonable costs of collection (attorneys’ fees)), the more likely the bad debt deduction will be allowed. Although no one factor is controlling, the courts have generally looked at the parties’ intent and the existence of the following as evidence that a bona fide debt exists: (1) a note or other evidence of indebtedness; (2) interest being charged; (3) a fixed repayment schedule; (4) security or collateral; (5) a demand for repayment; (6) the parties’ records, if any, reflecting the transaction as a loan; (7) any repayments made; and (8) the solvency of the borrower. Advances made after a family member becomes insolvent are deemed to be gifts, because a reasonable expectation of repayment could not exist when the advance is made; see Hunt, TC Memo 1989-335.

Legal action is not required to show that an effort was made to collect on the note. According to Regs. Sec. 1.166-2(b), if the circumstances indicate that legal action would in all probability not result in the ultimate collection of the debt from the borrower, a showing of these facts is sufficient evidence of worthlessness.

Note: Although loan formalities like those described above help establish the existence of a bona fide debt, a debtor-creditor relationship can still exist without them. Even in family situations, if the parties’ actions show that there was an actual intent to repay the loan and failure to do so was due to the eventual distressed financial condition of the borrower, a nonbusiness bad debt can be claimed; see Bowman, TC Memo 1995-259. The formality of a note or other legal evidence of a debt, in itself, is not conclusive that a bona fide debt exists. The intent of the parties to actually create a debtor-creditor relationship must be present; see Rodgers, TC Memo 1985-220. Nevertheless, the better the loan documentation, the better the chances of establishing the existence of a bona fide debt.

Intrafamily Loan Guarantees

If a taxpayer is called on to make a payment on a loan he or she has guaranteed, certain requirements must be met before a bad debt deduction for the payment can be claimed. To claim a deduction, the taxpayer must show that the guarantee was made in the course of his or her trade or business or in a transaction entered into for profit; see Regs. Sec. 1.166-9(d). In addition, the taxpayer must receive reasonable consideration for entering into the loan guarantee.

For the guarantee of a nonfamily member’s debt, the consideration can be either direct (i.e., cash or other property) or indirect. Indirect consideration is determined in accordance with normal business practice and may, for example, be in the form of improved business relationships. For the guarantee of a family member’s debt, however, the consideration must be direct, in the form of cash or other property; see Regs. Sec. 1.166-9(e)(1). For this purpose, “family member” is defined very broadly (e.g., includes in-laws and step-relationships) and includes all individuals listed in Sec. 152(d)(2).

Individuals often guarantee relatives’ loans as a personal favor and without direct consideration (i.e., cash or other property). This failure to receive direct consideration in exchange for entering into the guarantee agreement will prevent a taxpayer from claiming a bad debt deduction if he or she ultimately makes payment on the guarantee, even though he or she may improve his relationship with the lender; see Clanton, TC Memo 1995-416.

When payment is made under a loan guarantee, the taxpayer usually assumes the role of the original lender. Thus, payment under the guarantee generally gives the guarantor the right to, in turn, demand payment from the borrower. If this is the case, the guarantor taxpayer cannot claim a bad debt loss until reasonable collection efforts against the borrower have failed. Often, this means a bad debt loss will not be allowable in the same year payment under the guarantee occurs; see Regs. Sec. 1.166-9(e)(2). Once collection efforts have failed, the guarantor taxpayer has either a business or nonbusiness bad debt loss (or a gift), depending on the facts and circumstances of the taxpayer’s original guarantee transaction.

Example

Fred Ware Jr. wants to start his own business and estimates that he needs $25,000 of initial capital. The local bank will loan him this amount only if he can get the guarantee of his father, Fred, Sr. Alternatively, he may be able to get the funds directly from his father.

Fred Sr. believes his son’s business has a reasonable chance of success, and agrees to assist him. However, he would like to avoid an outright gift, so that Fred Jr. takes the business endeavor seriously. He would also like to claim a loss deduction in the event that Fred, Jr.’s business fails and he is ultimately out $25,000.

If Fred advances the funds directly to his son, he should ensure it is structured as a bona fide loan, evidenced by a signed promissory note with a fixed repayment schedule and reasonable interest charge. If, instead, he guarantees a bank loan for his son, he must make sure he receives direct consideration (i.e., cash or other property) from his son in exchange for entering into the guarantee agreement. The regulations offer no guidance as to how much constitutes a “reasonable amount” of consideration. Direct consideration is required to be eligible to claim a bad debt on an intrafamily loan guarantee and could, for example, be in the form of a cash fee or an ownership interest (e.g., stock) in the business. Either of these arrangements should enable Fred, Sr., to claim a nonbusiness bad debt deduction in the event he ultimately pays and is unable to collect repayment on the $25,000 advance to or for the benefit of his son.

If Fred Jr. ultimately defaults on the note and is unable to repay his father, he will likely have cancellation of debt (COD) income under Sec. 61(a)(12). However, to the extent he can show that he is insolvent when discharged, he may be able to avoid tax on the COD income under Sec. 108(a)(1)(B).