Debt worthlessness and tax deductibility – careful what you claim

Your Guide to State, Local, Federal, Estate + International Taxation

debt, tax, deductionA recent Tax Court ruling has brought to light the question of when is a debt worthless and considered a business bad debt eligible for a tax deduction. In Sarvak v. IRS, T.C. Memo 2018-68, Bradford Sarvak was disallowed his bad debt deduction on his S Corp tax return because he could not prove that the outstanding amount was objectively worthless in 2011 when he took the deduction. So, what does the IRS say is needed to establish proof that a bad debt is objectively worthless? According to Publication 535, “to demonstrate worthlessness, you must only show that you have taken reasonable steps to collect but were unable to do so.” Let’s discuss what Sarvak did that was not enough.

Bradford Sarvak, a real estate mortgage broker, was the president and sole shareholder of an S Corporation, Emery Financial Inc. Throughout 2011, multiple advances were made to William Boehringer and to others on his behalf totaling $362,122. These advances were recorded as a receivable on the ledger. These advances were unsecured and had no public record. At the end of 2011, an adjusting entry was made on the ledger to write off the loan receivable. According to Sarvak’s testimony, Boehringer told him that he could not repay the advances in early 2012. The Court determined that this was just Sarvak’s objective belief and there was no objective evidence to prove that the debt was worthless. There were no notes or documents, he had no proof that Boehringer was insolvent, Sarvak did not take any actions to collect and he continued to advance more funds in 2012 to Boehringer.

When debt is cancelled due to death or bankruptcy, it is a little easier to prove that a debt is worthless. However, if this is not the case, what and at what date makes debt worthless? If someone doesn’t pay for 12 months or 24 months, at what month is it worthless? This just reiterates how important it is to have documentation in your files and to really have support for any debt on your books including a note, terms and collection activity.

Kelsey Phillips, CPA, MBA