Tax Insights

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Establishing that Debt is Bona Fide Debt

Recently, there have been a number of cases disallowing bad debt deductions, particularly for loans to shareholders and related parties. If a related party loan becomes worthless, it is treated no differently from a debt to an unrelated party. Of course, this assumes the related party loan meets the bona fide debt standard. In order for a debt to be considered bona fide debt, the creditor/debtor must be able to show that at the time of the transaction, it had a real expectation of repayment and intent to enforce the collection of the indebtedness.

Often times, taxpayers’ advances to a closely-held entity are not documented or are ruled to be below-market loans. Loans to or from shareholders or other related entities should always be represented by a formal note. The note should bear a fair rate of interest and should be documented in the corporate minutes. Factors that the courts consider in determining whether a bona fide debt exists as the result of a transfer between related parties include:

  1. Documentary evidence of the transaction such as an executed note
  2. Whether there is a fixed schedule for repayment, including a maturity date
  3. Whether interest is being charged on the outstanding debt
  4. Whether collateral is obtained or requested
  5. Whether demand for repayment is made
  6. Whether any repayments have been made, and
  7. Whether the transaction is reflected as a debt in the books and records of the parties

So, it is good practice to document loans. This is easy to disregard with respect to related parties or shareholders. Even though repayment is intended, changes in financial conditions or other circumstances may affect repayment ability. Having an executed note will help support bad debt deductions.

By Kelly Lynch, CPA