Bad Debt Deduction Gone Bad (or The Worthwhileness of Proving Worthlessness)

Hatcher v. Commissioner, an unpublished per curiam opinion recently issued by the Fifth Circuit Court of Appeals, illustrates why taxpayers need to be sure that they can prove that a loan really became worthless in the year in which a bad debt deduction is claimed.

In this case, the taxpayers (hereafter “Taxpayers”) had married in 2010. Spouse A (hereafter “Wife”) had an undergraduate degree in business, a graduate degree in corporate finance, and had worked as a corporate executive for approximately nine years immediately prior to the marriage, during which time she’d held various positions, including corporate treasurer and head of finance and accounting. Spouse B (hereafter “Husband”) worked as a real estate professional and had begun his career focusing on commercial loan origination.

In 2004 through 2005, Wife had made an unsecured loan to her boyfriend at the time, later ex-boyfriend (hereafter “Ex-Boyfriend”). The loan was intended to cover Ex-Boyfriend’s personal expenses and expenses associated with developing “a golf-themed comic strip.” Wife didn’t look into Ex-Boyfriend’s financial history before making the loan. Although Wife had Ex-Boyfriend sign a series of promissory notes, she didn’t receive any ownership interest in the comic strip and didn’t charge any fees for making the loan. By the end of 2010, Wife had loaned Ex-Boyfriend a total of $430,500.00. That meant that after interest was factored in, Ex-Boyfriend was in hock to Wife in the amount of $582,553.16.

In December 2010, Wife had an email exchange with Ex-Boyfriend regarding repayment of the loan. Ex-Boyfriend was initially optimistic about being able to repay the loan. Shortly thereafter, however, Ex-Boyfriend sent an email to Wife reading, “I HAVE NO MONEY.” Ex-Boyfriend had only repaid $7,000 of the loan by the end of 2010.

On their 2010 federal income tax return, Taxpayers reported a negative adjusted gross income in the amount of $257,816.40. This loss resulted in part from a business bad debt deduction in the amount of $600,847.09 that Taxpayers had claimed in connection with Wife’s loan to Ex-Boyfriend. Wife then carried this loss back to her 2008 tax year, which resulted in the IRS issuing her a refund for that year in the amount of $105,353.17.

But the IRS wasn’t finished. In July 2013, the IRS sent a notice of deficiency to Taxpayers for their 2010 tax year, claiming that Taxpayers were responsible for a $100,924.00 deficiency and a $20,184.80 accuracy-related penalty. That same month, the IRS also sent a notice of deficiency to Wife for her 2008 tax year, claiming a $106,733.00 deficiency and a $21,346.60 accuracy-related penalty.

Taxpayers petitioned the Tax Court, seeking reconsideration of their alleged deficiency and penalty for the 2010 tax year. Wife did the same with regard to her 2008 tax year. The Tax Court consolidated the two cases.

Section 166 of the Internal Revenue Code provides a deduction for debts that become worthless during the taxable year. This section specifies different treatment for business and nonbusiness bad debts, with this designation determining whether a loss from a bad debt deduction can be carried back to earlier years.

But even assuming without deciding that Wife’s loan to Ex-Boyfriend would have constituted a business debt, the Tax Court found that Taxpayers had not proven that the debt had become worthless in 2010.

In order to claim a bad debt deduction, a taxpayer must be able to point to the occurrence of an identifiable event within the taxable year that caused the taxpayer to reasonably believe that the debt had become worthless. In this case, Taxpayers had argued that Ex-Boyfriend’s email in December 2010 stating that he didn’t have any money was just such an event.

Nevertheless, the Tax Court noted that Ex-Boyfriend had not made the declaration in his email under oath and that there was no evidence that Taxpayers had attempted to verify Ex-Boyfriend’s financial situation after receiving this email. The Tax Court also observed that Taxpayers sued Ex-Boyfriend to enforce the debt in 2011 – in other words, in the year after receiving the email in which Ex-Boyfriend claimed he was out of cash. And after winning a judgment against Ex-Boyfriend in 2012, Taxpayers engaged in discovery to identify income and assets that would satisfy the judgment, and Taxpayers continued to negotiate with Ex-Boyfriend in late 2012 in order to recover some portion of the debt. The Tax Court found it implausible that individuals with Taxpayers’ business backgrounds would continue to pursue such activities if they believed that the debt had become worthless in 2010. The Fifth Circuit agreed.

As Taxpayers hadn’t proven that the debt had become worthless in 2010, the Fifth Circuit upheld the Tax Court’s finding that a bad debt deduction was unavailable in that year and that, as such, there wasn’t a loss that could be carried back to 2008. After resolving a few other issues that were in dispute, the Fifth Circuit affirmed the Tax Court’s determination that Taxpayers were responsible for a deficiency of $100,625.00 and a $17,953.60 accuracy-related penalty for the 2010 tax year and that Wife was responsible for a deficiency of $105,353.00 and a $21,070.60 accuracy-related penalty for the 2008 tax year.

All of this goes to show that a taxpayer needs to be able to prove that a debt has become worthless before attempting to claim a bad debt deduction. And when proving worthlessness, it may be a good idea for a taxpayer to have more ammunition than an unsubstantiated email and to act like the loan is actually worthless in the years after the debt has supposedly gone bad.