Business loan fully deductible as ordinary loss
“The question is whether he can learn and change. If so, I believe he can be a good president.” — U.S. Sen. Dianne Feinstein, D-Calif., addressing a shocked Commonwealth Club on Aug. 29 in San Francisco
No matter your political affiliation, I think most reasonable people can agree that Presidents Barack Obama and Donald Trump have been the two most polarizing figures in recent political history. It is hard to have a conversation with anybody about either one of them without intense feelings interfering with a frank exchange of ideas and information. I cannot recall a time in my history when our country has been so bitterly politically divided. Perhaps we are indebted for her efforts toward reconciliation. Of course, this type of indebtedness does not generate a tax deduction, but there are some kinds that do.
In particular, the U.S. Tax Court has recently ruled that private loans made by an individual can sometimes be classified as business loans and deducted on our tax returns.
Typically, an individual loan that becomes worthless is deductible as a capital loss — allowing only $3,000 a year to be deducted against ordinary income (though it can offset any capital gains that you might have). However, a business loan is fully deductible as an ordinary loss.
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So, what is a business loan?
1. Trade or business
In order for a loan to be fully deductible, the lender must be in the trade or business of making loans. However, this does not require us to be a banker or a mortgage company; it merely means that you must be making loans on a continuous or regular basis with the primary purpose of earning income or a profit.
A simple example might be a wealthy individual who seeks to lend money at high interest rates to people who are struggling or new businesses that need capital.
A better example might be a parent who is lending money to his children and acquaintances for the same reason, but is also doing so primarily to improve the rate of return on his investment. With bonds paying so little interest, stocks paying so little dividends and banks paying so little on their certificates of deposit, such an individual could reasonably seek a higher income stream while at the same time helping those whom he cares about.
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2. Bona fide debt
A loan needs to have a “true debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable some of money.” This will require the use of a promissory note that contains the amount of money that was loaned, the interest rate, the dates that payments are to be made, the amount of interest, if there's any security for that loan and so on.
This new Tax Court case also addresses a couple of other interesting factors that can be included in the promissory note. It is allowable for the time and amount of repayment to be dependent upon earnings. This actually allows the borrower to use it in a business without the burden of immediate substantial repayment if hardship occurs.
Also, the note can be convertible into stock. Again, if properly handled, this would allow the lender to convert his loan to equity capital or to take over a failing business and restructure it so that the loan was more likely that he was to be paid.
Finally, the lender may subordinate his loan to other creditors. Although he has a lien on the assets of the borrower, he may allow other creditors to have a higher claim to that collateral as an incentive for the lender to obtain more funds if necessary and thereby improve the chances of the lender being repaid.
These last three items, while permissible, need to be carefully structured so that your loan is not converted into equity.
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3. Worthlessness
Assuming all these requirements are satisfied, we still must prove the day and amount that the loan became worthless. This is typically a question of fact and will depend upon the circumstances of each case. Factors may include bankruptcy, a significant decline in the borrower’s financial situation, change in the business climate, serious financial or medical hardship and so on.
Folks, the reality is banks are reluctant to lend money to new businesses, family members that don't have adequate collateral, newlyweds just starting out and to others who may not have a long history of substantial income or adequate collateral to justify the debt. It is common today for family members and friends to lend money to help them. Under certain circumstances, if the facts are just right and all the formalities are carefully followed, the lender can protect himself so that if the loan goes bad, he can deduct it on a tax return perhaps even as an ordinary loss.
Again, I think we are indebted to Feinstein for taking that first step. And again, although not tax deductible, I hope others find value in her comments and perhaps follow her lead.
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David Leeper is a board certified federal tax attorney with 38 years of experience. He can be reached at 581-8748, by email at leepertaxlawelpaso@gmail.com, or visit leepertaxlaw.com.