When you lend money or sell on credit and your debtor does not repay, you may deduct your loss. The type of deduction depends on whether the debt was incurred in a business or personal transaction. This distinction is important because business bad debts receive favored tax treatment.
A business bad debt is fully deductible from gross income on Schedule C if you are self-employed, or on Schedule F if your business is farming. You may deduct partially worthless business debts; see IRS Publication 535 for details.
A nonbusiness bad debt for 2012 is reported as a short-term capital loss on Form 8949 and then entered on Schedule D. You must attach a statement that describes the debt, your efforts to collect it, and your reasons for concluding that it had become worthless. As a short-term capital loss, a nonbusiness bad debt is deductible only from capital gains, if any, and $3,000 of ordinary income ($1,500 if married filing separately). Any excess is deductible as a capital loss carryover to 2013 and later years (5.4). You may not deduct partially worthless nonbusiness bad debts. The debt must be totally worthless.
Examples of nonbusiness bad debts:
If you guarantee a loan and must pay it off after the principal debtor defaults, your payment is deductible as a business bad debt if you had a business reason for the guarantee. For example, to protect a business relationship with a major client, you guarantee the client’s loan. Your payment on the guarantee qualifies as a business bad debt. If, as a result of your payment, you have a legal right to recover the amount from the client (right of subrogation or similar right), you may not claim a bad debt deduction unless that right is partially or totally worthless.
A loss on a guarantee may be a nonbusiness bad debt if you made the guarantee to protect an investment, such as where you are a main shareholder of a corporation and guarantee a bank loan to the company. No deduction is allowed if you guaranteed the loan as a favor to a relative or friend. Bank deposit losses are discussed in Chapter 18 (18.5).
It is a common practice for stockholders to make loans to their corporations or to guarantee loans made to the company by banks or other lenders. If the corporation fails and the stockholder is not repaid or has to make good on the guarantee, tax treatment of the bad debt depends on whether the stockholder is an employee who made the loan to protect his or her job. If the dominant motivation for the loan was to maintain employment, the bad debt is an employee business expense deductible only as a miscellaneous itemized deduction subject to the 2% of adjusted gross income floor (19.1). If the dominant motivation for the loan was to protect the stockholder’s investment in the company and not his or her job, the bad debt is generally a nonbusiness bad debt deductible on Form 8949/Schedule D as a short-term capital loss.
If the stockholder is in the business of lending money and the loan was made in that capacity, the bad debt would be a business bad debt, deductible on Schedule C by a sole proprietor.
52.15.42.128