A taxpayer walks into a tax practice and claims he incurred a loss due to a bad debt. This could be the first line of a joke, but it’s no laughing matter to a tax professional. The scenario triggers an important investigation into the details surrounding the taxpayer’s bad debt loss.
The most vital component of information is whether the debt was for a business or non-business purpose. Different results for the two types of debt are described in tax preparer courses. A business bad debt is tax deductible in the year it becomes worthless. Conversely, a non-business bad debt is treated as a short-term capital loss. This does not necessarily result in deduction of the non-business bad debt in the loss year.
A recent case in Tax Court contains elements about a bad debt arrangement that illustrate the subject like a sample question in an online tax course. The court decision complicates tax preparer work by ruling that a debt is non-business when the taxpayer’s primary purpose in making a loan is protecting an investment in a corporation.
The case involved an individual named Haury. He was a software engineer who developed a program and licensed it with two companies – NuParadigm Government Systems, Inc. (NPGS) and NPS Systems, Inc. (NPS). Mr. Haury was not the sole shareholder of these companies, but he was a major shareholder as well as a corporate officer. In the case of NPS, he was the only board member.
Both NPGS and NPS were subcontractors in 2006 on a project to develop software for a national alert warning system. This required about $4 million of costs for the companies. Haury withdrew funds from his IRA in 2007 to provide cash for the corporations. A series of promissory notes were executed for the companies to repay Haury with interest. Some of the money was repaid and Haury deposited the repayment back into his IRA. Whether the funds were returned to his IRA soon enough to avoid a taxable distribution was one issue for the court to decide.
After receiving money from Haury, NPGS borrowed $500,000 from a private investor under the condition that Haury subordinate his loans. The whole arrangement came crashing down at the end of 2007. Haury demanded that NPGS and NPS repay his loans. Neither company could pay. After that, Haury never again received compensation as an employee of either company.
The IRS prepared a substitute for return in 2010 covering Haury’s 2007 tax year. He received a deficiency notice, primarily because of his substantial income caused by the IRA withdrawals. Haury was also penalized for failing to file a tax return and make timely tax payments. When Haury subsequently filed his own 2007 tax return, he included a bad debt loss deduction of $413,000 that partially offset his $434,964 of IRA distributions.
The Tax Court concluded that the $120,000 Haury deposited back into his IRA did not comprise a rollover. The rule emphasized in tax continuing education about IRA rollovers is that they must occur no later than 60 days after a withdrawal of funds. Since Haury failed that standard, the court included the $120,000 as part of his taxable IRA distributions. He also owed the additional 10 percent tax for early distribution before reaching age 59½.
The bigger taxation course lesson about Haury rests with the nature of the debt. First, the Tax Court agreed that Haury had a bona fide debt that comprised an enforceable obligation to pay a fixed or determinable amount of money. However, the court did not agree with the actions of Haury for claiming the loss as a bad business debt on Schedule C. This conclusion relied upon the determination that Haury’s management of the companies and investment in them did not constitute a trade or business. The plain message for tax professionals is that evaluation of a taxpayer’s primary motivation for loaning money is crucial. The debt is non-business when the dominant incentive of the lender is protection of an investment.
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