Employee Allowed Itemized Deduction for Worthless Loan to Employer

Pwas the sole shareholder and salaried employee of K corporation, managing its daily operations. K had financial difficulties, so P lent K capital in an attempt to continue business operations and pay salaries to its 26 employees. K later filed for bankruptcy. On the final discharge of K’s debts, P’s loans remained unpaid and worthless because there were insufficient assets in the K’s estate to satisfy creditors.

P claimed a bad debt deduction for the loans to K on Schedule D, Capital Gains and Losses, and deducted the worthless debt on page 1 of his return on the line denominated “Other gains or (losses).” P now contends that he should have claimed the bad debt as a deduction on Schedule C, Profit or Loss From Business, to arrive at adjusted gross income (AGI). The IRS, on the other hand, allowed the loss as an itemized deduction in arriving at taxable income.

Law

Sec. 166 provides that a business bad debt is deductible as an ordinary deduction for the year in which the debt becomes worthless: “There shall be allowed as a deduction any debt which becomes worthless within the taxable year.” Sec. 166(d)(1)(A) states that in the case of a taxpayer other than a corporation, “subsection (a) shall not apply to any nonbusiness debt.” Sec. 166(d)(2)(A) and (B) define a nonbusiness debt as a debt other than:

(A) a debt created or acquired…in connection with a trade or business of the taxpayer; or

(B) a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.

Thus, subsection (a) allows an ordinary loss deduction only for business bad debts.

Being an employee may be a trade or business for Sec. 166 purposes. For example, an employee may need to lend money to an employer to stay employed. In this case, maintaining his employment was P’s dominant motivation. Accordingly, he made the loans in his trade or business of being an employee for Sec. 166 purposes. The Service concedes that P’s loans were bona fide debts that arose in the course of his trade or business of being an employee of K. The question is whether the bad debt should be allowed as a deduction from gross income to arrive at P’s AGI, or as an itemized deduction in computing taxable income.

The IRS relies on Sec. 62 and the related regulations in contending that bad debt deductions in connection with the trade or business of being an employee are treated as itemized deductions:

Sec. 62(a): Adjusted gross income defined.

General Rule.—For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions:

(1) Trade and business deductions.—The deductions allowed by this chapter (other than by part VII of this subchapter) which are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee. (Emphasis added.)

Thus, under the statute, items connected with the performance of services as an employee are not deductible in arriving at AGI. Accordingly, P’s business bad debt deduction is a miscellaneous itemized deduction subject to the Sec. 67 2% floor.

Kenneth W. Graves, TC Memo 2004-140