5.35 Family Bad Debts

The IRS views loans to relatives, especially to children and parents, as gifts, so that it is rather difficult to deduct family bad debts.

To overcome the presumption of a gift when you advance money to a relative, take the same steps you would in making a business loan. Take a note, set a definite payment date, and require interest and collateral. If the relative fails to pay, make an attempt to collect. Failure to enforce collection of a family debt is viewed by the courts as evidence of a gift, despite the taking of notes and the receipt of interest.

Caution

Formalize Loan With Relative

To protect against a possible IRS claim that your loan was a gift and not a loan, put the loan in writing with repayment terms as if the debtor were a third party.

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Husband’s default on child support—a basis for wife’s deductible bad debt?

A wife who supports her children when her husband defaults on court-ordered support payments may consider claiming her expenses as a nonbusiness bad debt deduction, arguing that her position is similar to a guarantor who pays a creditor when the principal debtor defaults. The IRS does not agree with the grounds of such a claim and will disallow the deduction; its position is supported by the Tax Court.

The federal appeals court for the Ninth Circuit left open the possibility that such a claim may have merit if a wife can show: (1) what she spent on the children; and (2) that her husband’s obligation to support was worthless in the year the deduction is claimed.

The Tax Court has subsequently reiterated its position that defaulted child support payments are not a basis for a bad debt deduction. Following these Tax Court decisions, the IRS also announced its continuing opposition to the Ninth Circuit’s suggestion that a deduction may be possible. The IRS holds that since the support obligation of the defaulting spouse is imposed directly by the divorce court, the other parent who pays support to make up for the arrearage has no “basis” to support a bad debt deduction.

Periodically, legislation has been proposed to allow a bad debt deduction for unpaid child support, but none of the proposals have been enacted into law.