When Business Loans Go Bad

September 30, 2014

Statistics show that most small businesses do not survive. Often, these companies finance their operations by borrowing money from the owners.  What happens to these loans if the company goes out of business?  If there is no hope of collecting on the debt, can the lender at least get a tax deduction?

The answer is yes, you can get a deduction.  To follow are the important points:

  • You must show that the debt is uncollectible.  If the business is insolvent and has no assets, your money is pretty much uncollectible.
  • You have to take the deduction in the year it becomes worthless.
  • You need basis in the loan.  Basis is beyond the scope of this post, but essentially means that the IRS did not already give you a tax deduction for the loan in a prior year.  Basis is likely to be an issue for companies that show losses for several years prior to going out of business.
  • The debt is treated as a short term capital loss.  That means that you are subject to the capital loss restrictions – offset capital gains first and then deduct up to $3,000 per year against ordinary income.
  • You have to tell the IRS about the loan.  The IRS wants a statement attached to the tax return that tells them the relevant information (name of the debtor, amount, the reason why it is uncollectible, etc).

As with all my posts, these are the general rules and are not applicable in all situations.  Do not use this as a substitute for professional tax advice.

For more information, contact our office.

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