PORTFOLIO

Bad Debts (Portfolio 538)

Tax Management Portfolio, Bad Debts, No. 538-3rd, discusses the problems that may arise in taking full advantage of debts that become worthless or partially worthless. It includes a complete discussion of the Internal Revenue Code provisions that govern the deduction of worthless debts and the application of these provisions to normally recurring situations. In addition, IRS rulings and court decisions pertaining to this subject are examined.

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Tax Management Portfolio, Bad Debts, No. 538-3rd, discusses the problems that may arise in taking full advantage of debts that become worthless or partially worthless. It includes a complete discussion of the Internal Revenue Code provisions that govern the deduction of worthless debts and the application of these provisions to normally recurring situations. In addition, IRS rulings and court decisions pertaining to this subject are examined.
The Portfolio also addresses problems which often arise in connection with bad debts, including: (1) whether a debt was worthless when incurred and, hence, not deductible under §166; (2) the application of §166 to obligations that arise by operation of law and to executory contracts; (3) status as debt, including the debt-equity issue in the §166 context; (4) the distinction between bad debts and losses; (5) determining when §165(g) (worthless securities) and §1271(a) (retirement or sale or exchange of debt instruments) apply instead of §166; (6) factors which establish worthlessness, and the distribution of the burden of proving worthlessness; (7) the consequences of repossessions and foreclosures; (8) the application of the tax benefit rule to recoveries of previously deducted bad debts; and (9) the application of the seven-year statute of limitations for refund claims on bad debts.


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AUTHORS

JOHN C. MCCOY
John C. McCoy, B.B.A., University of Notre Dame (1969); J.D., high honors, George Washington University (1976); Arent Fox, LLP since 1976, partner (1984–2003), counsel since 2004; member, District of Columbia, Virginia, Maryland, and American Bar Associations.

TABLE OF CONTENTS

Detailed Analysis

I. Overview

II. Legislative History

A. Early History

B. Internal Revenue Code of 1954

1. Bad Debts Originated by a Business

2. Guarantor's Losses: Former § 166(f)

C. Technical Amendments Act of 1958

D. P.L. 89-722: Reserve for Guarantees

E. The Tax Reform Act of 1986

F. P.L. 104-188: Repeal of Special Thrift Provisions

III. Existence and Nature of Debt

A. Existence of a Bona Fide Debt

1. Basic Concept of Debt

2. Debts Arising by Operation of Law

3. Unenforceable Obligations; Executory Contracts

4. The Taxpayer Must Be the Creditor

a. General Rule

b. Notes Discounted on Recourse Basis

5. Debts Worthless When Made

a. Poor Financial Condition of Debtor

b. Debts Arising by Operation of Law

6. Shareholder-Held Debt Distinguished from Equity

a. Nature of the Problem

b. Factual Nature of Resolution

c. Section 385

d. Capital Structure of Corporation

(1) Stock and Debt Held Pro Rata

(2) Thin Capitalization

(3) Nature of Assets

(4) Availability of Outside Credit

e. Nature of Instrument and Intent of Parties

(1) Appearance of Instrument

(2) Maturity Date

(3) Subordination

(4) Security for Payment

(5) Payment of Interest

(6) Repayment of Principal

(7) Indirect Equity Holdings

(8) Use of Hindsight

f. Guarantor Denied Status as Such

7. Debt Distinguished from Equity in Partnership Context

B. Bad Debts Versus Losses

1. Importance of Distinction

2. Debt-Connected Losses Related to Worthlessness and Not Governed by § 166

a. Corporate and Governmental Securities

b. Breach of Contract

c. Theft and Embezzlement Losses

d. Losses from Currency Revaluation

e. Debts Becoming Worthless by Reason of Expropriation or Other Taking

f. Certain Payments Associated with Guarantees and Indemnities

g. Paying Debts of a Corporation Other Than Pursuant to a Guarantee

h. Certain Deposits in Financial Institutions

3. Treatment of Amounts Received on Retirement

a. Application of § 1271(a)(1)

b. Debt Instruments Within the Meaning of § 1271(a)(1)

c. What Is a Retirement?

4. Installment Obligations

C. Special Reasons for Disallowance

1. Special Statutory Disallowances

a. Section 269: Acquisition to Avoid Tax

b. Section 165(j): Registration Required Obligations

c. Section 271: Debts Owed by Political Parties

d. Section 280E: Certain Illegal Activities

2. Where Allowance Would Result in Extra Tax Benefit

3. Avoiding Double Deduction Where Creditor and Debtor Are Affiliated

4. Debt Arising Out of Payment of Federal Income Taxes

5. Illegality

IV. Business Versus Nonbusiness Bad Debts

A. Tax Consequences of Characterization

B. Nonbusiness Bad Debt Defined

C. Taxpayer's Trade or Business

1. General Principles

2. Promoters; The Whipple Case

3. Where Loans to Corporations Are Not Denied Business Status Under the Whipple Doctrine

a. Where Taxpayer Is a True Promoter

b. Loans in Furtherance of Separate Business

c. Loans by Employees

D. Is a Profit Motive Required?

V. Guarantee Obligations

Introductory Material

A. General Principles

B. Business v. Nonbusiness Guarantee

C. Necessity of a Profit Motive

D. Subrogation Unnecessary

E. Guarantors of Corporate Obligations

F. Interest Not Deductible As Such

G. Timing of Deduction

VI. Worthlessness of a Debt

A. Definition of Worthlessness

B. Factors Indicating Worthlessness

1. In General

2. Banks and Regulated Businesses

a. General Rule - No Conformity Election

b. Conformity Election

(1) Effect of the Election

(2) Making the Election

C. Effect of Causes of Action Related to the Worthless Debt

D. Burden of Proving Worthlessness

VII. Claiming the Deductions

A. Maximum Allowable Deduction

1. General Rule

2. Effect on Basis of Prior Operating Losses of S Corporation Debtor

3. Effect on Basis of Prior Operating Losses of Debtor Taken on Consolidated Return

4. Effect on Basis of Deduction for Partially Worthless Debt in a Prior Year

B. Amount Deductible in Foreclosures and Repossessions

1. General Rule

2. Repossessions

3. Mortgage Foreclosures

a. Deduction on Foreclosure

b. Gain or Loss on Foreclosure

4. Reacquisition of Real Property; § 1038

VIII. Methods of Claiming the Deduction

Introductory Material

A. Specific Charge-Off Method

1. Wholly Worthless Debts

a. General Rule

b. Compromises and Partial Payments Distinguished

2. Partial Charge-Off of Specific Business Bad Debts

a. General Rule for Partial Charge-Offs

b. What Constitutes a "Charge-Off''?

c. Timing of the Deduction

B. Reserve Method (Repealed)

1. Repeal of the Reserve Method

2. Description of the Reserve Method

3. Changing from the Reserve Method

4. What's Left of the Reserve Method

a. In General

b. Financial Institutions

c. Accrual Method Service Providers

C. Statute of Limitations on Claiming Deduction

IX. Recovery of Bad Debts: § 111

A. Overview

B. Judicial Rule Requiring Inclusion in Income

C. Section 111 Exclusion from Income

D. Bad Debt Reserves

E. Correlation of Section 111 with Limitation of Deduction to Basis

F. Alternative Minimum Tax

X. Tax Consequences to the Debtor of Discharge of Indebtedness


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 1976 Amendment to § 166; General Explanation of the 1976 Amendment to § 166 by the Staff of the Joint Committee on Taxation

Worksheet 2 Repeal of the Availability of the Reserve Method of Accounting for Bad Debts for Most Taxpayers Under § 166 H.R. Rep. No. 841 (Conf.), 99th Cong., 2d Sess. II-314-16 (Sept. 18, 1986) To Accompany the Tax Reform Act of 1986 (H.R. 3838)

Worksheet 3 Text of Legislation Repealing the Availability of the Reserve Method of Accounting for Bad Debts for Most Taxpayers Under § 166, Section 805(a), (b) and (d) of the Tax Reform Act of 1986 (P.L. 99-514)

Worksheet 4 United States Bankruptcy Court Proof of Claim

Worksheet 5 Bad Debts - Excerpt from Pub. 334, Tax Guide for Small Business

Worksheet 6 Elections Available [under § 165] Involving Bad Debts for Individuals

Worksheet 7 Elections Available [under § 166] Involving Bad Debts for Financial Institutions

Bibliography

OFFICIAL

Statutes:

Treasury Regulations:

Committee Reports:

Treasury Rulings:

Cases:

UNOFFICIAL

Miscellaneous:

Tax Management Portfolios:

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