Business loans fully deductible as ordinary loss
“The question is whether he can learn and change. If so, I think he can be a good president. – US Senator Dianne Feinstein, D-Calif., Addressing a shocked Commonwealth club on August 29 in San Francisco
Regardless of your political affiliation, I think most reasonable people can agree that Presidents Barack Obama and Donald Trump were the two most polarizing figures in recent political history. It’s hard to have a conversation with anyone about either one without intense feelings interfering with a frank exchange of ideas and information. I don’t remember a time in my history when our country was so bitterly divided politically. We are perhaps indebted to him for his efforts at reconciliation. Of course, this type of debt does not generate a tax deduction, but there are some that do.
In particular, the United States Tax Court recently ruled that private loans made by an individual can sometimes be classified as business loans and deducted from our tax returns.
Typically, an individual loan that becomes worthless is deductible as a capital loss, so only $ 3,000 per year can be deducted from ordinary income (although it can offset any capital gains you might have. ). However, a business loan is fully deductible as an ordinary loss.
So what is a business loan?
1. Trade or business
For a loan to be fully deductible, the lender must be engaged in a business or commercial activity of making loans. However, this does not require us to be a banker or a mortgage company; it just means that you have to make loans on an ongoing or regular basis for the primary purpose of earning income or profit.
A simple example might be a wealthy person looking to lend money at high interest rates to people in difficulty or new businesses in need of capital.
A better example might be a parent who lends money to their children and acquaintances for the same reason, but also does so primarily to improve the rate of return on their investment. With bonds paying so little interest, stocks paying so little dividends, and banks paying so little on their certificates of deposit, such an individual could reasonably be seeking a higher stream of income while helping those they hold dear.
2. Debt in good faith
A loan must have a “true debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable part of money”. This will require the use of a promissory note that contains the amount of money that has been loaned, the interest rate, the dates on which payments are due, the amount of interest, if there is any collateral for this loan, etc.
This new Tax Court case also discusses some other interesting factors that may be included in the promissory note. The duration and amount of repayment is allowed to depend on income. This actually allows the borrower to use it in a business without the burden of immediate substantial repayment in the event of hardship.
In addition, the note may be convertible into shares. Again, if properly managed, this would allow the lender to convert their loan to equity or take over a struggling business and restructure it so that the loan has a better chance of being repaid.
Finally, the lender can subordinate his loan to other creditors. Although it has a lien on the assets of the borrower, it may allow other creditors to have a higher right to this collateral in order to induce the lender to obtain more funds if necessary and thus improve the repayment chances from the lender.
These last three elements, while permissible, must be carefully structured so that your loan does not convert to equity.
Assuming all of these conditions are met, we still have to prove the day and amount when the loan became worthless. This is usually a question of fact and will depend on the circumstances of each case. Factors can include bankruptcy, a significant decline in the borrower’s financial situation, a change in the business climate, serious financial or medical difficulties, etc.
Folks, the reality is that banks are reluctant to lend money to new businesses, to family members who don’t have adequate collateral, to newlyweds just starting out, and to others who can’t. – not have a long history of substantial income or adequate collateral to justify the debt. It is common today for family members and friends to lend money to help them. In certain circumstances, if the facts are correct and all formalities are followed carefully, the lender can protect themselves so that if the loan goes badly, they can deduct it on a tax return perhaps even as an ordinary loss.
Again, I think we are indebted to Feinstein for taking that first step. And again, while not tax deductible, I hope others will find value in his comments and perhaps follow his lead.