When is a client’s bad debt worthless — and tax deductible?
If your client has loaned money to someone but has been unable to collect the debt, they cannot suddenly write it off come tax time, just because they think the debt is worthless, according to a recent Tax Court ruling.
A debt that becomes wholly worthless within the taxable year is deductible as a business bad debt. To deduct a business bad debt, the client must show the existence of a valid debtor-creditor relationship, that the debt was created or acquired in connection with a trade or business, the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless.
The recent Tax Court case, Sarvak v. IRS, T.C. Memo 2018-68, illustrates the problem with determining just when a debt becomes worthless. It faulted the taxpayer for not providing objective proof that a bad debt became worthless in the year he claimed.
Bradford Sarvak was a real estate mortgage broker doing business as Emery Financial, an S corporation of which he was president and sole shareholder. In 2011, Emery made a series of advances to William Boehringer and to others on Boehringer’s behalf totaling $362,122. The advances were made by checks, credit card payments and wire transfers, and were recorded on Emery’s general ledger as a loan receivable from Boehringer.
Sarvak met Boehringer in 2003, when Sarvak purchased a lot in Aspen, Colorado, from him, which he developed and later sold. He was familiar with other projects of Boehringer’s over the years. The advances he made in 2011 were unsecured, and neither Emery nor Sarvak made a public filing to record a debt in connection with the advances.
An adjusting entry in Emery’s general ledger for Dec. 31, 2011, reflects that Sarvak instructed that the loan receivable for the 2011 advances be written off.
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A bad debt is deductible only for the year in which it becomes worthless. Worthlessness is determined by an objective standard, and is usually shown by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery, according to the court. “The subjective opinion of the taxpayer that the debt is uncollectible, without more, is not sufficient evidence that the debt is worthless,” the court said.
“[Sarvak] failed to present any evidence that the alleged debt was objectively worthless in 2011,” the court observed. “He testified only as to his subjective belief.”
Sarvak testified that Boehringer told him in early 2012 that he could not repay the 2011 advances, but Sarvak offered no reasoning as to why, in that case, the alleged debt should be treated as worthless on Dec. 31, 2011. Moreover, according to the court, even accepting Sarvak’s uncorroborated testimony, Boehringer’s 2012 statement would not be enough to establish that the alleged debt to Emery was objectively worthless.
“[Sarvak] did not describe any actions taken to try to collect the alleged debt, and he testified that he did not know whether Boehringer was actually insolvent in 2012,” it stated. “There is no reasonable explanation for advancing more funds to Boehringer in 2012, which [Sarvak] also described as a business loan, if the prior advances were deemed totally unrecoverable.”
“It’s not that easy to decide when a debt actually becomes worthless,” said Roger Harris, president of Padgett Business Services. “If someone dies or goes into bankruptcy, that makes it worthless. But if they don’t pay for 24 months, why is it a bad debt in the 25th month, when it’s not a bad debt in the 12th or 18th month?”
“At some point, it makes sense to decide, ‘I’ve had enough, I’ll write it off,’” he continued. “But you have to show the proper documentation, any attempts to collect and the reason it’s worthless now. Sometimes you’re just tired of trying to collect it but you can’t point to a singular event – you just gave up.”