Introduction
Mo is a shareholder and an employee of the Lunar Corporation. The company, which is closely held, owes money to Mo. The shareholder has decided to stop the operations of the company. Further, Mo wants to write off the loans as a bad debt expense on the returns for the personal tax.
Issue
Should Mo write off the loans as a bad debt expense on the returns for the personal tax?
Conclusion
Based on the facts of the case, it can be established that the bad debt has a proximate relationship with Lunar Corporation. Thus, it will be treated as a business debt. This implies that Mo cannot write off the loans as a bad debt expense on her tax return. The loss can be counterbalanced from regular income. The shareholder can also use the loss to compute carry-back relief.
Analysis
As a general rule, Internal Revenue Code Section 165 outlines that “losses which are sustained during the year and have not been compensated for by insurance or other means can be subtracted during the taxable year” (Cornell University Law School 1). Further, Internal Revenue Code Section 165 (g) (1) outlines that “if any security which a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset” (Cornell University Law School 1).
Further, Section 165 (g) (2) gives an outline of items that fall under the term “security” as used in Section 165 (g) (1). Some of the items are a share of stock, the right to receive or subscribe to a share of stock, and any evidence of indebtedness issued by a company. Thus, this section allows companies to write off worthless securities such as debt instruments issued by the company (Cornell University Law School 1).
The Internal Revenue Code Section 166 (d) (1) (b) outlines that in the case of a taxpayer, “a loss resulting from a nonbusiness debt that becomes worthless within the taxable year shall be treated as a loss from the sale or exchange of a capital asset held for not more than one year” (Cornell University Law School 1). The loss is deducted during the taxable year. Thus, this section allows a taxpayer to deduct losses that arise from worthless nonbusiness debt.
Further, Regulations section 1.166-5 (a) (1) and (2) only allow corporations to deduct losses arising from nonbusiness debts. Other taxpayers can similarly treat the worthless nonbusiness debts as losses that arise when trading capital assets. In the case of United States V. Genres, 405 U.S 93 (1972), a debt a closely held corporation owed to an indemnifying shareholder-employee became worthless (Cornell University Law School 1).
In this case, it was important to establish whether the worthless obligation was a business or a nonbusiness obligation. In the ruling, it was established that the bad debt had a proximate relationship with the taxpayer’s business. Thus, it qualified for a business bad debt. The facts in the case of United States V. Genres, 405 U.S 93 (1972) are similar to the scenario in Lunar Corporation. Mo is a shareholder and an employee of the company. Further, the company owes Mo money.
Works Cited
Cornell University Law School 2014, 26 U.S Code Part VI – Itemized Deductions for Individuals and Corporation. Web.