Arguing the case for a business bad debt deduction.

When a shareholder loans money to a corporation, there is a clear expectation that the loan will be
repaid. If the loan becomes worthless, deductibility of the loss for tax purposes is based on two
criteria: whether (1) a bona fide debt existed, since advances that are not bona fide loans are
generally characterized as capital contributions, and (2) the loan is classified as a business or
nonbusiness debt. Business bad debts that are completely or partially worthless are deductible as
ordinary losses, while nonbusiness bad debts are short-term capital losses only when entirely
worthless.(1)
Under Sec. 166(d)(2), a business bad debt occurs either from a debt created or acquired in
connection with the taxpayer's trade or business, or from the worthlessness of a debt incurred in the
taxpayer's trade or business. The distinction between a business and nonbusiness bad debt is a
question of fact and must be determined based on the facts and circumstances. The courts, however,
have established minimum criteria that must be met before a business bad debt deduction will be
allowed. A general understanding of these criteria can be helpful in establishing the conditions
under which the courts may allow a business bad debt deduction. This article will discuss these
minimum criteria and provide practical suggestions for shareholders who are contemplating making
(or have already made) loans to a corporation, to enhance the likelihood of ordinary loss treatment
should the loan become worthless. This article will also discuss the tax consequences when a
shareholder guarantees corporate loans.
Debt Versus Capital Contribution
Before considering whether a loan is a business or nonbusiness debt, the shareholder must first
establish that the loan is not a contribution to capital. Often, a shareholder of a closely held
corporation will advance funds to it without formally documenting that the advance is a loan that is
expected to be repaid in the future.(2) This can be a costly mistake if the corporation becomes
insolvent and the debt becomes worthless, since only bona fide loans qualify as bad debt losses
under Sec. 166.(3)
A bona fide debt "arises from a debtor-creditor relationship based upon a valid and enforceable
obligation to pay a fixed or determinable sum of money."(4) In assessing whether an advance to a
corporation is a loan or a capital contribution, the courts have concluded that the primary factor is
the intent of the parties to the transaction.(5) However, this requires a subjective determination of
an individual's state of mind at the time the advance was made. In determining the shareholder's
intent in advancing funds to a corporation, the courts have identified numerous factors to be
considered, including the following:
1. Whether and how the transaction was accounted for on the corporation's books.
2. Whether the taxpayer and the corporation executed a written agreement.
3. Whether the corporation paid or accrued interest on the loan and whether the taxpayer reported
interest income from it.
4. Whether repayment was contingent or based on the corporation's earnings.
5. Whether the debt was subordinated to other general creditors and if so, to what extent.

6. The level of capitalization of the corporation.(6)

Provided the corporation is not deemed "thinly capitalized," a properly documented loan agreement,
regular interest payments and proper accounting FridayWire SEO on the corporation's books should
generally preclude a reclassification of a loan as a capital contribution.(7)
Guarantors' Losses
When a taxpayer makes payments in satisfaction of an agreement under which the taxpayer acted as
a guarantor of a debt obligation, a debtor-creditor relationship arises. A payment in discharge of a
taxpayer's obligation under such an agreement is treated as a bad debt when all of the following
conditions exist:
1. The agreement was entered into in the course of the taxpayer's trade or business or a transaction
for profit;
2. There was an enforceable legal duty on the taxpayer to make the payment; and
3. The agreement was entered into before the obligation became worthless.(8)
Under the doctrine of subrogation, the taxpayer's debt does not exist until the corporation defaults
on the payment and the taxpayer is forced to satisfy his guarantor obligation.(9) Consequently, a
deduction for a bad debt is not allowed until the taxpayer's rights against the debtor become
worthless. However, if the debt is worthless when acquired (as in the case of a guarantor that
acquired subrogation rights as the result of a default on the debt by an insolvent corporation], the
regulations allow the taxpayer a bad debt deduction by testing the validity of the debt at the time the
guarantee obligation was entered into, rather than at the time the guarantor satisfies the
obligation.(10)
Business Versus Nonbusiness Bad Debt
Once it has been established that an advance (or a payment made on a guarantee of an obligation) is
a bona fide debt, the taxpayer must determine the type of debt it is. Sec. 166(d)(2) defines a
nonbusiness debt as a debt other than one created or acquired in connection with the taxpayer's
trade or business, or one in which the loss from worthlessness was incurred in the taxpayer's trade
or business. Accordingly, two conditions must exist before a worthless debt is classified as a
business bad debt: (1) the taxpayer must be engaged in a trade or business; and (2) at the time the
debt was acquired, created or became worthless, it must have been related to the taxpayer's trade
or business.(11)
Although a shareholder is generally not considered to be engaged in the same trade or business as
that of the corporation, shareholders have been successful in claiming ordinary losses for worthless
loans to a corporation by establishing that they made the loan either in their capacity as an
employee or in the trade or business of acquiring corporations. (Both of these arguments are
discussed later.
In determining whether the loss from the debt was incurred in the taxpayer's trade or business, a
debt that is "proximately related" to the taxpayer's trade or business either when the debt was
acquired or created, or at the time of worthlessness, is a business bad debt.(12) Although the extent
to which the acquisition or worthlessness of a debt is related to the taxpayer's trade or business is a
question of fact that must be determined based on the facts and circumstances, the courts have

developed certain criteria that must be met before a deduction for a business bad debt will be
allowed.
In Generes,(13) the Supreme Court concluded that the proper test in determining whether a bad
debt was proximately related to the taxpayer's trade or business is "dominant," rather than
"significant," motivation. Generes earned $12,000 working part-time as president of a construction
company in which he owned 44% of the stock. He took a $162,000 business bad debt deduction for
payments made to a bonding company that had loaned money to the corporation under an indemnity
agreement with the taxpayer.(14) The Court found no evidence to support the taxpayer's claim that
his "sole" motivation in signing the indemnity agreement was to protect his salary and position as an
employee.
The Supreme Court instructed the courts to "compare the risk against the potential reward and give
proper emphasis to the objective rather than to the subjective" in determining whether a taxpayer's
dominant motivation is attributable to his trade or business.(15) In reaching its decision, the Court
weighed heavily the following objective factors:
* Generes derived three-quarters of his total income from other sources.
* His investment in the corporation was significantly larger than his annual salary.
* The remainder of the corporation's stock was owned by close relatives.
Before a taxpayer can claim that the dominant motivation behind a debt was attributable to his trade
or business, the taxpayer first must be engaged in a trade or business. For purposes of Sec. 166, a
shareholder generally is not in the same trade or business as the corporation, even when the
shareholder owns a controlling interest.(16) However, to the extent that the shareholder is also an
employee of the corporation, the shareholder is in the trade or business of being an employee.
Trade or Business of Being an Employee
To satisfy the dominant motivation standard, an employee of a corporation must demonstrate that
the loan was made to the corporation (or third-party loans were guaranteed) to protect his salary
and position as an employee. Clearly, when the employee does not own an equity interest in the
company, there is no issue concerning the taxpayer's motives for making the loan. However, in an
attempt to motivate employees, it is becoming more common for companies to ask or require highlevel employees to make equity investments in the business, or to make or guarantee business loans.
In these situations, the loans or guarantees should clearly qualify as business loans, because the
dominant motive for making them is to protect the employee's position in the company.
In general, the key factors to be considered by shareholder-employees who make loans to (or
guarantee loans of) a corporation include:
* The level of investment in the company.
* The level of salary received from the company.
* The amount of the loan or guarantee in relation to the first two factors.
* The amount of income derived from other sources.

* The relative size of the taxpayer's investment in the corporation to his annual salary.
* The taxpayer's ownership percentage in the corporation and his relationship to those owning the
remainder of the corporation's stock.
* The taxpayer's ability to find comparable employment elsewhere.(17) The Litwin(18) case
illustrates how these various factors have been used in determining a taxpayer's dominant
motivation behind making and guaranteeing loans. Litwin sold his wholly owned corporation, but
continued to work for the company and act as chairman of the board. After a subsequent change in
ownership, his responsibilities and salary were reduced. At the time, the Litwin was 73 and unable
to find comparable employment elsewhere. In an attempt to provide himself with employment and a
comparable salary, Litwin started another business.
Although the new business had good long-term prospects, it developed cash flow problems. To keep
the business going, Litwin made several loans to the corporation and guaranteed loans from banks
that totaled over $1.5 million. Because of the company's cash problems, Litwin deferred part or all of
his salary for several years.
Later on, he sold a controlling interest in the company, retaining only a small percentage of its
stock. The bank, however, required Litwin to renew his guarantee on the loans to the corporation.
Eventually, the corporation failed and he was forced to honor his guarantees to the bank. Litwin
deducted as business bad debts the payments that were made to the bank in satisfaction of these
guarantees. The district court ruled in Litwin's favor and allowed a business bad debt deduction.
In determining Litwin's motives for making and guaranteeing the loans, the court considered the
taxpayer's age and the fact that the loan guarantee ultimately satisfied was actually a renewal of the
guarantees after he sold a controlling interest in the business. As a result, the return Litwin could
have expected from his investment in the company was significantly lower than the salary he
received. Notwithstanding the fact that the guarantee might have been necessary to complete the
sale transaction, Litwin apparently demonstrated to the court that it was entered into to protect his
continued employment. Had Litwin not sold his controlling interest in the company, a different
conclusion regarding his motives might have been reached. Finally, the considerable amount of time
Litwin spent working with and for the company after selling most of his stock was an important
factor.
Generally, if a taxpayer's investment (at the time of the loan or guarantee) in the company is
substantially less than his company salary, a strong argument can be made that the loan or
guarantee was made to protect the salary income. Also, when a taxpayer is actively engaged in the
management of a business, without expectation of significant future capital gain, the employmentrelated argument is strengthened. Even when the potential gains from the taxpayer's equity interest
could be larger than the amounts received as salary, the courts have not ruled out the possibility
that the taxpayer could have had a dominant employment-related motive for making loans to the
corporation.(19)
Another significant aspect in support of a business bad debt classification is that many shareholderemployees rely on their salary, not on their investment (which may or may not be substantial relative
to salary), to pay day-to-day living expenses, since investments generally do not provide regular cash
income.
Example: T is a vice president and 10% owner of a personal service corporation (PSC). The PSC was
initially capitalized at $100,000, making T's initial investment $10,000. The shareholders of the PSC

personally guarantee loans to the corporation; T's share of such guarantees is (100,000.(20) If T's
annual salary as a vice president is $65,000, it would be difficult for the IRS to argue successfully
that T guaranteed loans in excess of his salary to protect a $10,000 investment.(21) Instead, a strong
argument could be made that T's dominant motivation for guaranteeing the loans must have been to
maintain his salary and position in the company, and that he was not primarily concerned with the
value of the investment.
This argument becomes even stronger when the taxpayer's right to sell stock is limited by the
corporation (e.g., a provision granting the corporation the right of first refusal on any sale of stock
by the taxpayer, using a formula that is not directly related to market value to determine the
purchase price). Additionally, in the case of a PSC, when a shareholder will receive only the return
of his initial investment on departure from the company, there is little doubt that loans or
guarantees of loans made by the taxpayer were made in his capacity as an employee, not to protect
his investment. However, if the taxpayer could easily earn a similar salary elsewhere without
guaranteeing the corporation's debt, this argument is weakened.
When a taxpayer loans money to a business he created in the belief that he could work only for a
corporation in which he held a substantial ownership interest, the courts have held that the taxpayer
must provide convincing evidence that the primary motivation for starting up the business was his
inability to work for others.(22) However, other valid business reasons exist for starting up a
business, and if the only way the taxpayer can receive a salary is by establishing his own business,
provided that the appropriate criteria have been met, a business bad debt deduction should be
allowed. This argument should apply even when the potential for capital gain is apparent.
Trade or Business of Acquiring Corporations
A taxpayer may also claim a business bad debt deduction as a shareholder-employee by
demonstrating that he is in the trade or business of seeking out business ventures to acquire,
promote, finance, derive a salary from and sell at a profit. This approach is somewhat more limited,
as it is more appropriate for entrepreneurs who are major shareholders of several corporations, each
of which the taxpayer is actively involved in managing or promoting.
When the taxpayer is engaged in a trade or business that involves several businesses, a debt
connected to one of the taxpayer's endeavors is per se connected to his overall trade or
business.(23) However, for a taxpayer to argue successfully that he is in the trade or business of
acquiring corporations, he must be able to distinguish his activities from those of an investor.
A debt created or acquired in connection with an activity which, when taken alone, does not
constitute a trade or business, but rather is viewed as a segment of a larger overall trade or
business, qualifies as a business bad debt with respect to the overall trade or business, provided the
relevant criteria are met.(24) Again, it is important for the taxpayer to establish that the kinds of
gains derived from the endeavor are not the same as those marking an investor's return (which are
generally characterized as gain from dividends or enhancement in the value of the investment).
When the taxpayer's primary return from the business is ordinary income and the potential for
substantial capital gain is relatively small, it is more likely that the court will find a business motive
behind the shareholder's loan to the corporation.
Even if the taxpayer's return is directly linked to the services he provides to the corporation, the
Supreme Court has held that when the return is that of an investor, the taxpayer has not satisfied
the burden of demonstrating that he is engaged in a trade or business. Additionally, if full-time
service to one corporation does not constitute a trade or business, it is difficult to establish how the

same service to several corporations constitutes a trade or business.(25) However, if the type of
return is that of a noninvestor, it is possible that the activity will be considered a trade or business.
In making this determination, both the extent to which the taxpayer performs these services and the
amount of ordinary income generated from such services are important factors.
In some instances, activities not traditionally considered to be a trade or business may be classified
as such when they are performed extensively and result in the primary source of income to the
taxpayer. For example, if the taxpayer derives the majority of his income from and spends the
majority of his time in the pursuit of profit from trading securities, he will be deemed to be engaged
in the trade or business of being a securities trader.(26) Another example is a taxpayer who, as a
livelihood, devotes the majority of his time and effort to speculating on the stock exchange. In this
case, losses incurred as a result of these activities may be treated as having been incurred in the
course of a trade or business.(27)
In general, the key factors to be considered when determining whether the taxpayer is in the trade
or business of seeking out business ventures to acquire, promote, finance, derive a salary from and
sell at a profit are:
* The taxpayer's income and time spent in pursuit of profit from such activity in relation to other
activities.
* The number of business ventures the taxpayer participated in during the relevant periods.
* The types of services provided by the taxpayer.
The argument of being in the business of seeking out business opportunities that could be profitably
financed or promoted is enhanced if the taxpayer participates in numerous business ventures
throughout the relevant periods of the case. For example, support for the claim may exist if the
taxpayer could list five specific loans he made that allowed the debtors to acquire businesses, as well
as at least five other ventures in which he invested in hopes of deriving a profit from the future sale
of their investments. This argument would be strengthened if the taxpayer could show that he
typically invested in or financed these companies, served as financial adviser to the debtors or
managers of the businesses, and then sold the interests, usually to the persons who were managing
the companies.(28)
Similarly, a taxpayer who bought and sold over 30 businesses generally would be considered to be
engaged in the trade or business of developing and promoting businesses, primarily because buying
and selling businesses for profit may constitute a trade or business, even though the promoter does
not receive a fee, commission or other "noninvestor" compensation.29 In such instances, it is
necessary for the taxpayer to demonstrate that the dominant motivation behind buying and selling
businesses was to earn ordinary income, not to realize potentially large amounts of capital gain. To
support this argument, the taxpayer might have to substantiate that he took an active role in
developing and promoting the businesses.
Timing of the Deduction
In general, a bad debt deduction is allowed in the tax year in which the debt becomes worthless. For
a business bad debt, a loss is also deductible when the loan becomes partially worthless.(30) For
loan guarantees, provided the bad debt criteria have been met, the deduction is allowed in the tax
year in which payment is made. When either a cash-or accrual-basis taxpayer satisfies his obligation
under such an agreement with a promissory note, the deduction is allowed when the note is paid, as

a bad debt arises only after the taxpayer has made an outlay of cash or of property having a cash
value.(31)
Therefore, in situations in which the taxpayer is forced to satisfy a guarantee obligation but does not
have the cash available, he may be tempted to sign a note promising to pay the debt in the future.
However, the taxpayer is better off borrowing the money from a third party (e.g., a financial
institution) to satisfy the obligation. Under both scenarios, the taxpayer must repay the corporation's
initial debt; however, in the latter case, the taxpayer is able to claim a bad debt deduction
immediately.
Conclusion
When a taxpayer is a shareholder-employee in a closely held corporation, the salary derived from his
position as an employee is often greater than the amount of his investment in the company. In such a
case, the IRS may presume that the taxpayer loaned money to or guaranteed loans of the
corporation (usually in amounts far exceeding both investment and salary) to protect his investment
in the company. It is more likely, however, that the taxpayer loaned money to (or guaranteed loans
of) the corporation either as a condition of employment or to help get the business off the ground
and provide himself with a salary. In these cases, it is more reasonable to assume that the taxpayer
loaned money to the corporation to preserve a periodic income to cover ordinary living expenses,
and that the investment was of secondary concern relative to this desire.
The argument can be made for a taxpayer to claim a business bad debt deduction for advances made
or guarantees of loans to a corporation of which he is both a shareholder and employee, provided
that the facts clearly indicate that the taxpayer's dominant motivation for the loans was to protect
his salary and position as an employee. Several cases also support the notion that extensive business
activity in the area of corporate acquisitions can constitute a trade or business, and that bad debts
related to such a business are deductible as business bad debts. However, before taking a position
with respect to the deductibility of a bad debt, taxpayers finding themselves in either of these two
positions should consider whether they are able to produce enough evidence to support a business
bad debt deduction, as the final determination of any bad debt case rests on an analysis of the facts
and circumstances.
Accordingly, when a taxpayer loans money to or guarantees loans of a corporation, a written
agreement should be prepared that clearly reflects the taxpayer's reasons for entering into the
agreement. To successfully claim a business bad debt deduction in the event that the debt becomes
worthless, the circumstances at the time of the agreement should support the taxpayer's contention
regarding his motivation. The following is a list of suggestions that may be used to support the
taxpayer's intentions.
* A written agreement should be executed, stating the terms of the loan.
* The loan should be interest-bearing (using a market rate of interest), made to the corporation, and
not specifically subordinated to the corporation's general creditors.
* When guaranteeing a loan on behalf of a corporation, the shareholder should document on the
bank note the purpose of the guarantee.
* In the case of a shareholder-employee who is required to make loans to the corporation, the
employment agreement should be clarified to reflect that the employee is required to loan money to
or guarantee the debts of the corporation in his capacity as a (senior) employee of the company. (1)

Regs. Sec. 1. 166-5(a)12). (2) In the case of a shareholder with See. 1244 stock, it may be more
beneficial to the taxpayer to have the debt reclassified as equity. (3) Regs. See. 1.166-1(c). (4) Id. (5)
This assumes that the corporation is not thinly capitalized. See Los Angeles Shipbuilding & Drydock
Corp., 289 F2d 222 (9th Cir. 1961)(7 AFTR2D 984, 61-1 USTC [paragraph]9329); and Jeannette H.
Jennings, 272 F2d 842 (7th Cir. 1959)(4 AFTR2D 6000, 60-1 USTC [paragraph]9136). (6) Otis
Newell Elliott, 268 F Supp 521 (DC Ore. 1967)(19 AFTR2D 1323; 67-1 USTC [paragraph]H9368);
Leonard Lundgren, 376 F2d 623 (9th Cir. 1967)(19 AFTR2D 1407,67-1 USTC [paragraph]9389);
John W. Hough, 882 F2d 1271 (7th Cir. 1989)(64 AFTR2D 89-5569, 89-2 USTC [paragraph]9508),
aff'g TC Memo milwaukee 1986-229; Ray A. Van Clief, 135 F2d 254 (D.C. Cir. 1943)(30 AFTR 1417,
43-1 USTC 99384). (7) Even when the debt is clearly identified as such and treated as a debt on the
corporate books, it may be reclassified as equity if the debt-to-equity ratio suggests that the
corporation is thinly capitalized. Plantation Patterns, Inc., 462 F2d 712 15th Cir. 1972)(29 AFTR2D
72-1408, 72-2 USTC [paragraph]9494), cert. denied. (8) Regs. Sec. 1.166-9(d). However, a bad debt
deduction would not be allowed if, at the time the obligation was entered into, the shareholderguarantor's payment is construed as a contribution to capital. (9) Max Putnam, 352 US 82 (1956)(50
AFTR 502, 57-1 USTC [paragraph]9200), aff'g 224 F2d 947 (8th Cir. 19551(47 AFTR 1562, 55-2
USTC [paragraph]19604), aff'g TC Memo 1954-141. (10) Regs. Sec. 1.166-9(c). (11) Regs. Sec.
1.166-5(b). (12) Id. (13) Edna Generes, 405 US 93 11972)(29 AFTR2D 72-609, 72-1 USTC
[paragraph]19259). For purposes of loan guarantees, the dominant motivation test is applied at the
time the guarantee obligation was entered into, not at the time of payment (Regs. Sec. 1. 1669(d)(1)). (14) This was treated as a bad debt because the company defaulted on several projects and
subsequently went into receivership, leaving the taxpayer with no possibility for recovery from the
company. This should not be confused with a situation in which the taxpayer makes payments under
such a guarantee with an expectation of repayment from the company. (15) Generes, note 13, at 721 USTC 83,960. (16) "|A corporation and its stockholders are generally to be treated as separate
entities.'" A.f. Whipple, 373 US 193 (1963)(11 AFTR2D 1454,63-1 USTC [paragraph]19466), citing
Burnet v. R.P. Clark, 287 US 410 (1932)(11 AFTR 1103, 3 USTC [paragraph]10101, at 63-1 USTC
88,268. (17) Harry Litwin, 983 F2d 997 (10th Cir. 1993)(71 AFTR2D 93-647, 93-1 USTC
[paragraph]50,041), aff'g DC Kans., 1991 (67 AFTR2D 91-1098, 91-1 USTC [paragraph]150,229);
Generes, note 13; James C. Garner, 987 F2d 267 (5th Cir. 1993)(71 AFTR2D 93-1307, 93-1 USTC
[paragraph]50,167), aff'g TC Memo 1991-569. (18) Litwin, id. (19) Litwin, note 17. (20) In this
situation, it is possible that some or all of the loan guarantees may be reclassified as capital
contributions if the Service argues that the corporation is thinly capitalized. See note 7. (21) In a
PSC, amounts are generally paid out to owners as salary, as opposed to dividends or capital gains.
(22) Donald C. Niblock, Jr., 417 F2d 1185 (7th Cir. 1969)(24 AFTR2D 69-5792, 69-2 USTC
[paragraph]9704), aff'g TC Memo 1968-260. (23) Vincent C. Giblin, 227 F2d 692 (5th Cir. 1955)(48
AFTR 478, 56-1 USTC [paragraph]9103). (24) Lundgren, note 6. (25) Whipple, note 16. (26) Samuel
B. Levin, 597 F2d 760 (Ct. Cl. 1979)(43 AFTR2D 79-1057, 79-1 USTC [paragraph]9331), adopting
Trial Judge's Report (U.S. Ct. Cl. Trial Div. 1979)(43 AFTR2D 79-612, 79-9 USTC [paragraph]9176).
(27) John A. Snyder, 295 US 134 11935)(15 AFTR 1081, 35-1 USTC [paragraph]9344). (28) Elliott,
note 6. (29) Frank L. Farrar, TC Memo 1988-385. (30) See. 166(a)(2). (31) Stanley Halle, TC Memo
1983-760; Black Gold Energy Corp., 99 TC 482 (1992).
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