It depends.
If a shareholder's loan to a corporation becomes worthless, the debt must be considered bona fide to qualify for a bad-debt deduction [Reg. 1.166-1(c)]. To be considered a bona fide debt, the loan must meet demanding standards, especially when the shareholder is considered a related party.
Factors that the courts consider in determining whether a bona fide debt exists as a result of a transfer between related parties include:
1. The presence or absence of documentary evidence of the transaction (such as an executed note);
2. Whether there is a fixed schedule for repayment (including a maturity date);
3. Whether interest is being charged on the outstanding debt;
4. Whether collateral is obtained or requested;
5. Whether demand for repayment is made;
6. Whether any repayments have been made;
7. Whether the transaction is reflected as debt in the records of the parties; and
8. The financial condition of the debtor at the time of the loan (so that the lender can show the expectation of repayment and intent to create a valid debtor-creditor relationship).
To preserve a bad-debt deduction, and support the fact that a true debt exists, shareholder loans to a corporation should always be represented by a formal note. The note should bear a fair rate of interest and should be authorized in the corporate minutes.
If the corporation had no ability to borrow from a bank, the IRS may consider the "loan" to the corporation an investment or equity interest if the above 8 steps cannot be met.
