By: Amanda Wilson
For partnership, individuals and other types of taxpayers that are not in the business of making loans, the main avenue for tax relief when a loan goes bad is Section 166 - the bad debt deduction. In order to claim this deduction, the taxpayer must show that the debt has become wholly worthless during the tax year in which the deduction is claimed. This can often be a very difficult burden for taxpayers, especially if there is no external event that they can identify as a trigger for worthlessness. Even if there is such an event (such as the borrower declaring bankruptcy), worthlessness can be difficult to establish.
A recent Tax Court decision illustrates the difficulties that taxpayers face when claiming a worthless debt deduction. In Cooper v. Commissioner (T.C. Memo 2015-191), the Tax Court found that the taxpayers failed to show that a debt became worthless in 2008, the year that they claimed the deduction. This was despite the fact that the borrower declared bankruptcy in 2008. The Tax Court pointed to the fact that (i) the taxpayers did not initially claim the debt as worthless on their tax return (they claimed the deduction in 2010 when they filed an amended 2008 return), (ii) they listed the loan as an asset in 2009 on statements of net worth, and (iii) they did not issue the borrower a 1099 in 2008 reflecting cancellation of debt income. While the Tax Court did not specifically state when the debt became worthless, it seemed to indicate that this occurred in 2010. Of course, had the taxpayers claimed that the debt became wholly worthless in 2010, the IRS may very well have taken the position that the debt was in fact wholly worthless in 2008, when the bankruptcy petition was filed, especially if enough time had passed that the taxpayers would have been barred from filing an amended 2008 return.