Business Bad Debt classification

[Zeus11]

I am an individual taxpayer. 

In the case of taxpayers other than corporations, Section 166 distinguishes business bad debts from nonbusiness bad debts, providing that a business bad debt can be deducted against a taxpayer’s ordinary income, whereas a nonbusiness bad debt must be treated as a short-term capital loss.  The Code defines a business debt as a “debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.”  Taxpayers have the burden of proving that a bad debt loss is “proximately related” to the conduct of a trade or business, or that the debt was created in the course of a trade or business.

What exactly is proximally related?  I understand if I were in the business of making loans, and had a Sched C business for loans, it is pretty clear, right?  But what if I founded a company making sweatshirts, making sweatshirts is my trade, and I make a loan (with promissory, board notes, and all the other boxes checked) to that C Corp, and that is defaulted on or worthless before the business goes bankrupt?  Is that proximally related and becomes an ordinary deduction?  If it were only loans as the business or trade, then the IRS would likely have specified that in their publications, but it was left deliberately vague as "in connection with a business or trade of the taxpayer".  Thoughts on how to classify?

[Mike9241]

 loan was made to protect your employment it's a business bad debt. if it's to protect your investment it's anon-business bad debt.  this is based on various court rulings.  As an employee of the corporation and that employment is your primary employment, the you can often make a reasonable showing that the loan was made to protect your business as an employee (and not just as an investment). In that situation, business bad debt treatment should be available. That is, if you believed the corporation needed the loan to keep your job going, that should be enough.

Problems arise when your motivation relates more to the investment side of things, and not protection of your employment. This tends to come up more when the you are both an employee and a stockholder. In a court case, this opens the door to a strong argument that the loan was made more to protect the lender's investment in the company than his or her employment. There, the taxpayer lost his bid for business bad debt treatment. In finding that the loan was a nonbusiness bad debt instead, it noted:

The dominant motivation for making the loans was not petitioner's trade or business as an employee of the companies. the taxpayer 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. What was especially problematic for the taxpayer was that in the year after the loan was made, the lender did not receive any pay. While not explicitly discussed, the Court's mentioning of this fact presumably helped it reach the conclusion that the loan was not made principally for employment purposes. Whether it would have ruled for the taxpayer if the lender continued to receive compensation is unknown.

Harry R. Haury, TC Memo 2012-215

You should be able to use the above court case to decide whether the loan was employment related or investment related, No on fact is determinative.