By: A.J. Cook

Hard economic times mean uncollectible loans. Could there be a bad debt tax deduction waiting for you?

Oenia C. Vaughters wrote a check for $108,000 to her son, Ralph McCurdy, for his farming operation on leased acreage. He promised: "If I do well, you'll get back more than you put in." They agreed he should support his family out of profits, then any remaining profits would go to his mother. After she received $108,000, she and her son would share equally.

The farm, near Texarkana, Tex., did well -- for the first three years. The son distributed profits as planned. Then came the drought -- both to the crops and payments to Mom. He started borrowing from the Bank of Dixie in Lake Providence, La., to keep the farm afloat. Despite the stream of money -- it sank.

Mrs. Vaughters took a bad debt deduction of $101,619, the unreimbursed amount plus his loans she paid off at the bank. The IRS disallowed the deduction saying the son wasn't obligated to repay. She appealed.

The judge agreed with the IRS. Neither party treated the transaction as an enforceable loan. For example, the son didn't sign a promissory note with interest and a repayment schedule.

This case shows a basic requirement for a bad debt deduction. The key, treat the loan like a bank would.

The Moral: Neither an informal borrower nor lender be.

Even though Cynthia A. Beshear had a typical promissory note signed by her ex-husband -- the IRS said "No" to her deduction.

Ms. Beshear and Edward J. Cunningham fell in love during college. After they married she worked to put him through law school and helped him set up a law practice in Mountain Home, Ark. Much of his office equipment and library came from her deceased father's law practice. She assisted in locating and negotiating the purchase of land for his law office building, assisted in designing it and decorated the interior, solicited clients and worked as the firm's unpaid bookkeeper.

Then they divorced. He got the Corvette, a four-plex apartment building, their interest in the law firm and firm office building. He signed a note promising to pay her $162,000 in installments. She got everything else: their home, Lincoln car, bank stock, river cabin, pick-up truck and a Texas farm.

The next year Cunningham remarried. One year later, he died. His estate didn't have enough money to pay the remaining $128,150 on the note.

Ms. Beshear claimed a bad debt deduction. The IRS disallowed it saying the debt related to alimony. The agency pointed out that certain uncollectible obligations are not deductible -- wages, fees, rent, alimony -- unless previously included in taxpayer's income.

In court she argued the note was not for alimony, but rather payment for building up her first husband and his law firm. The judge disagreed. The note signed by Cunningham didn't read like a payment for assets. Instead, it looked like an alimony obligation: payments were unsecured and would stop at her death. Furthermore, there was no provision for her support other than the note.

The Moral: Bad debts seldom add up profitably.

Can you get a tax deduction for a loan to your brother-in-law?

Joe E. Mellen tried. The successful Hertz Rent-A Car businessman from Lexington, Ky., could afford to loan $9,800 to Jean Hisgen. His brother-in-law, who just lost his job, signed a note and put the money in his new business. After nine months the business unraveled with secured creditors taking what few assets Hisgen had. He abandoned the business and went to work as a painter for minimum wages.

Mellen, of course, deducted the loan on his tax return. The Internal Revenue Service, which scrutinizes intra-family deals carefully, said the rent-a-car owner bought himself a truckload of trouble. It said the money was a gift; Mellen didn't try to collect it. Mellen explained that he didn't try because his attorney said collection efforts would be fruitless, considering Hisgen's insolvency. The agency ignored the pleas.

Mellen appealed. With the support of his brother-in-law's testimony, Mellen convinced the judge this was a loan. Allowing the deduction the judge said, legal action would have yielded no money.

The Moral: Worthless brother-in-laws make for worthless debts.

Melvin McCain of Seattle, Wash., a commodity futures broker, wanted to help an old friend and customer who was down and out. When his friend lost his job, he asked McCain for $5,000.

At tax time McCain claimed the $5,000 as a bad debt. The IRS said not to bet on that deduction's future. No bad debt is allowed if the loan was worthless when made.

McCain went to court. He said his friend became a "hopeless wreck" after the loan.

But the judge said nothing proves the friend was in any better condition, financially or otherwise, at the time of the advance. The judge agreed with the IRS's deduction disallowance, adding that nothing other than the notation "loan" on McCain's check indicated a debt.

The Moral: Hope is the essence of a loan -- not generosity.

Attorney Dennis A. Roth of Moreland Hills, Ohio, loaned money to Vincent Amato, the number three executives with his number two client.

Amato needed money because of his divorce. He signed a note due in 90 days with interest. When the note became due, he begged for more time. Nine months later Amato disappeared.

Frustrated by various dead-end attempts to find Amato, Roth abandoned hope. He deducted the debt on his tax return.

Three years later the attorney's secretary recognized Amato on the evening news, working as acting Safety Director for the City of Cleveland. Roth got a court order garnishing Amato's wages.

Meanwhile, the IRS, examining Roth's tax returns, became aware of his renewed collection efforts: Now it wanted the deduction thrown out. The agency said the debt wasn't worthless the year deducted.

The attorney went to court, where the judge allowed the deduction. "Disappearance of the debtor, coupled with an apparent lack of leviable assets," justified it, the judge said. "The mere fact of Amato's reappearance, . . . bringing with it new hope of repayment, is irrelevant to the issue of worthlessness" in the earlier year.

The Moral: Neither a borrower nor a lender be -- avoid the bad debt question altogether.

Getting a bad debt deduction for money loaned to a relative is relatively difficult.

Richard and Alice Mann and their business, Mann Construction Co. Inc., however, got a deduction by doing a few things right.

The Redmond, Oregon company prospered at first. Its receipts reached $7 million - - mostly from work on military bases and national parks. But hard times came and most of its employees, including the owners’ son Mark, had to look for other work.

The company loaned Mark money for his support. During a 10-year period, Mark signed notes agreeing to pay the debt plus interest. The loan reached $126,653 - - $175,049 with interest. Mark paid back only $57,046.

The company took a bad debt deduction when Mark hit on hard times. He was unemployed, owed $24,256 and alimony and child support payments. His only assets were a used truck and a $15,000 travel trailer, which he lived in.

After the Internal Revenue Service disallowed the deduction, the company appealed.

The court looked for evidence to determine if the money was a loan or a gift.

Intra family loans are subject to rigid scrutiny and presumed to be gifts. This can be rebutted by proving an expectation of repayment and a real intent to enforce collection. Courts consider the following:

• Borrower was solvent at time of the loan.
  
• A note evidencing the debt.
  
• A schedule for repayment.
  
• Security or collateral.
  
• Interest was charged.
  
• Some repayments.
  
• A demand for repayment.
  

The following were not present in the construction company case: collateral, schedule of repayment and demand for repayment. Surprisingly, the court allowed the deduction.

Even if you show this was a bona fide loan, it's difficult to prove you aggressively pursued collecting it. One judge said you need a better explanation than to say it was "inconvenient." Another judge asked a parent whether he tried to collect the loan. The father replied: "You can't get blood out of a turnip."

The Moral: You can't get blood out of an IRS agent either.

Planning Tip: When loaning money to a relative or friend, plan for a bad-debt deduction:

Get evidence to show the debtor was solvent when you made the loan.

Structure the transaction like a loan to a stranger.

Make certain the debtor signs an interest-bearing note payable as described in the note and get collateral.

Take the deduction in the year the debtor becomes insolvent.

A.J. Cook is a lawyer and CPA. His tax column appears weekly in numerous newspapers. Why isn't it published in your hometown newspaper? Ask its Business Editor to subscribe.

Copyright © 1987-2001 A.J. Cook All Rights Reserved
This information is not intended for use without professional advise.
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Released 10-5-92, 1-27-92 and 2-14-00