Tax Court Denies Bad Debt Deduction

In Herrers, TC Memo 2012-308, the Tax Court sustained a deficiency asserted against a married couple who reported pass-through bad debt deductions from a limited liability company named HSA. The Herrers’ claimed such bad debt deduction on the grounds that a related corporation did not repay a debt owed to HSA. The Herrers owned interests in both companies. HSA had transferred cash in excess of $500,000.00 to the related company.

Bona fide business bad debts are deductible against ordinary income whether wholly or partially worthless during the year the debt becomes worthless. A bona fide debt is one which arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money. The Internal Revenue Service is very critical of advances and loans between related entities.

The Tax Court disallowed the deduction because the debt was not bona fide and was instead an advance between related entities. The Tax Court relied on the lack of a promissory note, bond, or indenture evidencing the indebtedness; the lack of a maturity date; the lack of a repayment schedule; the lack of security or collateral for the loan; and the subordination of HSA’s debt. The Tax Court also emphasized that HSA did not require interest payments, which clearly demonstrated that the debt was not bona fide and instead was an advance.

Important: If you are operating two related entities and plan on making a loan from one entity to the other, then you should consult an attorney to ensure that the loan is bona fide. At the very least, make sure to execute a promissory note, include a maturity date and repayment schedule, require security or collateral for the loan, do not subordinate the debt to other debts, ensure that the indebted company has sufficient capital to pay the loan and make sure interest payments are made on the loan.