Tax Rules for Claiming Bad Debt Loss Deductions

The issue of individual taxpayers deducting bad debt losses has historically been a source of tension with the IRS. Here’s what you need to know to get the best tax results for your situation.

Basic Tax Rules for Bad Debts

To claim a deductible bad debt loss, an individual taxpayer must first prove that the loss was from a bona fide loan transaction. You can’t claim a deduction simply from an ill-advised decision, such as a capital contribution to a failed business or an informal advance to a friend or relative that was never repaid and turned out to be an unintended gift.

Assuming you can establish that there was a bona fide debt that has now become worthless, the next issue is whether the loan can be classified as a business loan rather than a nonbusiness loan. For federal income tax purposes, this is an important distinction.

Business bad debts. For federal income tax purposes, business bad debt losses are treated as ordinary losses that can usually be deducted currently without any limitations. In addition, partial deductions can be claimed for business loans that go partially bad.

Nonbusiness bad debts. These debts receive less favorable tax treatment than the business variety. If an individual taxpayer incurs a nonbusiness bad debt loss, it’s treated as a short-term capital loss (STCL) under the federal income tax rules. STCLs fall under the annual limitation on net capital loss deductions. The current limit is $3,000 per year ($1,500 per year for married people who file separately). Individual taxpayers can’t deduct losses for partially worthless nonbusiness bad debts.

One gray area is the treatment of bad debt losses from loans that employees make to their employers. Under current tax law, these losses receive even less favorable treatment than nonbusiness bad debt losses.

Losses from Loans to Employers

When an employee makes a loan to his or her employer that results in a bad debt loss, the loss is generally classified as an unreimbursed employee business expense. Before the Tax Cuts and Jobs Act (TCJA), you could write off miscellaneous itemized expenses, including unreimbursed employee business expenses, to the extent that the total exceeded 2% of your adjusted gross income.

However, the TCJA suspended itemized deductions for miscellaneous expenses for 2018 through 2025. So under current law, you can’t deduct a loss from a soured loan made to your employer. It’s unclear whether Congress will extend this unfavorable TCJA provision beyond 2025.

Important: It’s often difficult to pinpoint the exact tax year that a debt becomes worthless. So, the normal three-year statute of limitations for filing amended returns to claim a bad debt loss deduction and the resulting tax refund doesn’t apply. Instead, a seven-year statute of limitations generally applies.

Establishing the Existence of a Bona Fide Debt

The first step towards claiming a deductible bad debt loss is proving that the loss was from a bona fide loan transaction. An instructive decision from the U.S. Court of Appeals for the Sixth Circuit supplies some helpful guidance (Indmar Products Co., Inc. v. Commissioner, 444 F.3d 771, 6th Cir. 2006). The court concluded that shareholders’ cash advances to their closely held corporation were loans rather than equity investments in the corporation based on the following 10 factors:

1. Loan documentation. The claim that a cash advance is a bona fide loan is strengthened if the arrangement is described as debt on the borrower’s financial records and a receivable on the lender’s financial records.

2. Maturity date and repayment schedule. A formal agreement that specifies a fixed maturity date and defined repayment schedule indicates a loan exists. A history of repayments of purported loan principal amounts can also help prove that a cash advance is a bona fide loan.

3. Interest rate and payments. Charging a fixed interest rate and making timely payments of fixed-rate interest suggest that a cash advance is a loan.

4. Source of repayment funds. Relying on a borrower’s profits to generate cash to repay a loan is generally more characteristic of an equity investment than a loan. Realistically, however, operating profits are often the main source of repayment, even for legitimate third-party loans.

5. Debt-to-equity ratio. In the context of a purported loan to a corporation, an excessively high debt-to-equity ratio may indicate that a cash advance is an equity investment rather than a loan. However, this factor is essentially moot when the corporation demonstrates a pattern of repaying principal and interest on the purported debt.

6. Overlap between shareholders and lenders. In the context of purported loans by shareholders to a corporation, cash advances made strictly in proportion to stock ownership percentages are more indicative of equity investments than loans.

7. Security. A cash advance made without adequate security (such as a pledge of collateral or a personal guarantee) generally indicates an equity investment rather than a loan.

8. Availability of outside debt sources. When the recipient of funds can demonstrably obtain third-party debt financing, a cash advance is more likely to be considered a loan than an equity investment.

9. Subordination. Subordination of purported loans to all debt owed to third-party creditors is indicative of equity investments rather than loans.

10. Use of proceeds. If a cash advance is used to buy a long-term capital asset, the arrangement will likely be considered an equity investment. Conversely, using the proceeds as working capital typically indicates a loan. However, many real-world businesses take out legitimate third-party loans to buy capital assets.

Taxpayers can adapt these factors when evaluating other types of cash advances to determine the proper tax treatment.

Identifying Business Bad Debt Losses

After establishing that a bona fide debt exists, the next step for an individual taxpayer to claim a deductible bad debt loss is determining whether the debt is a business or nonbusiness debt. Characterizing a bad debt loss as a business bad debt loss is preferable. Making that call is easy if the taxpayer is in the business of making loans. If not, making the call may be harder.

According to the IRS, there must be a “proximate relationship” between your business and the loan for you to claim a business bad debt loss. In the case of United States v. Generes (405 U.S. 93, 1972), the U.S. Supreme Court stated that to pass the proximate-relationship test, there must be a dominant business motivation for making the loan. Having only a significant business motivation isn’t enough to pass the test.

The proximate-relationship test is easier to pass when the loan is made to support your own business. For example, a sole proprietor might pass the test if he or she makes a loan to help a critically important vendor or customer stay afloat.

Important: In many real-life situations, the facts may not support claims that soured debts are business bad debts. In such cases, the losses will be nonbusiness bad debt losses that must be treated as STCLs, and the capital loss deduction limitation will apply.

Supporting Bad Debt Claims

The IRS closely scrutinizes bad debt loss deductions claimed by individual taxpayers. That said, you may have a legitimate bad debt loss that can be deducted on your yet-to-be filed 2024 tax return or an amended return for an earlier year. If so, consider working with your tax advisor to establish the necessary documentation if the IRS questions your deduction. Maintaining detailed records is especially important for bad debt losses from loans to friends and relatives.

Copyright 2025

This article appeared in Walz Group’s March 17, 2025 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.