When a borrower defaults on a loan and the lender forgives all or a portion of the loan, tax law treats the amount of the loan that remains unpaid as “cancellation of debt” (COD) income to the borrower. If the borrower is a pass-through entity like a partnership, that “income” is reported to the partners for tax purposes even though no money actually changes hands.
When a default occurs, tax law typically allows the lender to claim a bad debt deduction. However, the character of this loss may limit the amount that the lender may deduct in certain (fairly common) circumstances. So, when a partner loans money to a partnership and the partnership subsequently defaults, it’s quite possible that the partner will have to report ordinary COD income that flows through from the partnership at the same time that the partner’s deduction for the bad debt may be limited under the law because it’s treated as a short-term capital loss. You read that right. A partner could lend money, lose some or all of the money lent, receive taxable income from the partnership for some or all of the money lost, and face limits on any corresponding deduction for the bad debt.
This article will look a little more closely at how this unfavorable result can come about and discuss some options for structuring these transactions in a manner that permits the lender to deduct the full amount of the bad debt for tax purposes.
A quick look at the law
U.S. tax law classifies bad debts into “business” and “non-business,” and the law treats these two classes differently.
A business bad debt is:
- Related to a loan made in the ordinary course of the taxpayer’s trade or business.
- Treated as an “ordinary” deduction.
- Deductible even when the debt is only partially worthless to the extent of the loan impairment.
A non-business bad debt is:
- Related to a loan made outside of the taxpayer’s ordinary trade or business.
- Treated as a short-term capital loss because the debt is related to a deemed investment activity.
- Deductible only when it becomes totally worthless.
COD income is generally treated as ordinary income to the borrower.
If the loan is between two unrelated parties and the lender is in the trade or business of lending money, the amount of the loan determined to be uncollectable is typically a business bad debt that generates an ordinary deduction for the lender. When the loan is between two related parties, the amount determined to be uncollectable may qualify as business bad debt in some circumstances and non-business bad debt in others. Bad debts arising from loans by corporations are always considered business bad debts, but in the case of a Subchapter S corporation, the loss may be considered a non-business bad debt because this is a pass-through entity for tax purposes.
The law is not quite as clear when it comes to classifying bad debt expenses that arise from a related party loan made by an individual or between partnerships as business or non-business. In a few specific circumstances, courts have indicated that they are open to the argument that losses on a loan like this can be considered business bad debt by the lender. However, the Internal Revenue Service (IRS) almost always seems to conclude that the classification is a non-business debt in these circumstances and that the bad debt expense should be treated as a short-term capital loss. This is because the lender is not considered to have made the loan in the ordinary course of the lender’s trade or business.
Key takeaways and planning opportunities
First and foremost, the most important thing to remember is that if you’re a partner in a partnership and the business is considering structuring a loan from either a partner or a related entity to the business, consult with a tax advisor about the potential tax ramifications. If you make the loan without any additional planning and the partnership defaults, you could wind up with ordinary COD income and a corresponding short-term capital loss that is worth considerably less. Having a partner make a preferred capital contribution instead may avoid this unfortunate tax consequence.
Second, consider creating a new financing entity with the sole purpose of loaning funds to the related entities. This separate entity could treat any losses related to default as a business bad debt and generate an ordinary deduction. Because this is the sole business activity of this lending entity, the IRS would be more likely to consider its lending losses to be business bad debts.
If you have any questions about the tax treatment of bad debts arising from loans between related parties, please let us know.