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Business Bad Debt Or Capital Loss?

Business Law discussions

Business Bad Debt Or Capital Loss?

Postby Rong » Mon Aug 15, 2016 7:20 am

s About Taxes)/business bad debt or capital loss? Advertisement Expert: Richard Fritzler - 2/4/2011 i loaned money to 4 LLC's in which I am minority member. The loans cannot be repaid by the LLCs due to business losses and all the bank loans defaulted. The loans were arm's length with a promisssory note. Any interest not payable due to cash shortage plus all additional advances  for working capital were added to principal so the note was like a line of credit. The llcs were capitalized with only loans from members and banks. Is the write off of my loans treated as a business bad debt or a capital loss?

ANSWER: Let's start with:

The LLCs are "Disregarded Entities" by the IRS. You were in 4 general partnerships, as far as the IRS is concerned. Then, since you were a member, these are not arms length.

Finally, you could write it off as bad debt, and the LLC would be attributed that bad debt as income. That attribution would be passed to the members as taxable. If everything works perfectly, you will pay no more or no less in taxes when it is all said and done. But, income is subject to Self Employment taxes, while bad debt losses do not offset against SE taxes. This effectively increases your taxes due.

Richard Fritzler

---------- FOLLOW-UP ----------

Thanks. But here's the rub: I would get 100% of the bad debt write-off and only a fraction(my % ownership# of the partnership COD income. Since the LLCs are passive investments, would my write off be a passive loss as well? Even if it is, upon liquidation, the net passive losses would be freed up and therefore deductible against ordinary income from other sources, correct? The issue of self employment taxes has never come up for me because(a) no income has ever been realized,  (b)these are real estate rental LLCs, and(c) I did not think self employment tax was applicable to an LLC. Am I wrong? BTW, my CPA thinks the bad debts are capital losses to me, not bad debt losses,and the LLCs when liquidated will write off the notes payable as a charge against equity, decreasing the capital accounts(and therefore members' tax basis), which will increase our gain on disposition which is a capital gain. But to test this, he's willing to  file twice: initially as capital losses and the amended 1040 as business bad debts. He says(as do other experts I've read) that I'm an investor, not a lender and therefore am not "in the business" of a lender even though I made four separate loans with promissory noteswhich is required to take a bad debt write off. Plus, the LLCs were all funded with no equity, just bank debt and member debt so the debt could be characterized as equity by the IRS. Finally, where on my schedules would I show business bad debts: somewhere on schedule E?

Thanks again.
Rong
 
Posts: 38
Joined: Wed Jan 22, 2014 10:34 pm

Business Bad Debt Or Capital Loss?

Postby Txanton » Tue Aug 16, 2016 5:46 am

When it comes to the IRS you can always make an argument. Our first recommendation is to avoid the argument, and our fall back position is to be prepared to make a strong and accurate argument.

Just to be exquisitely clear, loan and investment are not interchangeable terms. As you re-read your explanation I think you'll see where that could get you into trouble.

Regardless your experts understanding; "Investors" purchase assets, while "Lenders" make loans. Your "casual" involvement in the lending business doesn't dismiss you from the title of lender, but if you are lucky, it might keep you out of the purview of your State "Mortgage Lending Division", and having to comply with their additional standards of performance. On the other hand you might not avoid that either, you'll need to do the research on that.

However, you might not be a lender, you might, as you claim, be an investor. Here is the possibility on the other side: The IRS takes the opposition position that requires: You have valid Notes for each of these "Loans"? By note, I mean a WRITTEN agreement, that declares it is a LOAN, AND that prescribes the AMOUNT OF THE LOAN, the TERMS of the loan, and a REASONABLE INTEREST RATE. If you are successful in this then depending on the total amounts and/or frequency and/or other criteria, you could be required to register with the Mortgage Lending Division within your State and get a license. If you don't have said note, then it is not a loan and you are not a lender. It is, by absolute definition, a gift and you are a generous person with no right to recover anything. That would be your worst result. Your second best position would be that it was additional capital contribution either for additional ownership interest, or just as additional contribution from an existing owner, and you would have a right to claim it as a loss.

Additionally, even with all the loan documentation, the IRS normally seeks to reclassify "loans" from stockholders(or in your case members/general partners) as capitalization. So the repayment of said loan is really a dividend and taxable as income. Since the "Lender" still has a residual interest once the loan is paid off, it would be reasonable to consider them Investors.

If you are going to attempt to make a strong argument, you can't afford to mix these details.

Your accountant should certainly be willing to file for you both ways, he has nothing at risk, at your worst, you'll be paying him more. But you have some risk, and you need to balance that against the possible reward. This type of tax strategy we normally classify as "Good Til Audit". And an Audit will not happen this year, nor the next, most likely it will be 3 years from now. If you are unsuccessful, then your deduction is simply disallowed. You would owe the back taxes, plus penalties, and Interest. At that point you can file an amended return and hope to get the original deduction, but you will still owe the back taxes, penalties and interest. I don't know what the dollar levels are here, if were talking about a grand. . . it might not even be noticed. If it is noticed it'll cost you more just to deal with it than you saved. If were talking hundreds of thousands, you are more likely to be in the fight.

Richard
Txanton
 
Posts: 42
Joined: Thu Jan 30, 2014 7:44 pm

Business Bad Debt Or Capital Loss?

Postby Arlo » Wed Aug 17, 2016 1:41 pm

s About Taxes)/business bad debt or capital loss? Advertisement Expert: Richard Fritzler - 2/4/2011 i loaned money to 4 LLC's in which I am minority member. The loans cannot be repaid by the LLCs due to business losses and all the bank loans defaulted. The loans were arm's length with a promisssory note. Any interest not payable due to cash shortage plus all additional advances  for working capital were added to principal so the note was like a line of credit. The llcs were capitalized with only loans from members and banks. Is the write off of my loans treated as a business bad debt or a capital loss?

ANSWER: Let's start with:

The LLCs are "Disregarded Entities" by the IRS. You were in 4 general partnerships, as far as the IRS is concerned. Then, since you were a member, these are not arms length.

Finally, you could write it off as bad debt, and the LLC would be attributed that bad debt as income. That attribution would be passed to the members as taxable. If everything works perfectly, you will pay no more or no less in taxes when it is all said and done. But, income is subject to Self Employment taxes, while bad debt losses do not offset against SE taxes. This effectively increases your taxes due.

Richard Fritzler

---------- FOLLOW-UP ----------

Thanks. But here's the rub: I would get 100% of the bad debt write-off and only a fraction(my % ownership# of the partnership COD income. Since the LLCs are passive investments, would my write off be a passive loss as well? Even if it is, upon liquidation, the net passive losses would be freed up and therefore deductible against ordinary income from other sources, correct? The issue of self employment taxes has never come up for me because(a) no income has ever been realized,  (b)these are real estate rental LLCs, and(c) I did not think self employment tax was applicable to an LLC. Am I wrong? BTW, my CPA thinks the bad debts are capital losses to me, not bad debt losses,and the LLCs when liquidated will write off the notes payable as a charge against equity, decreasing the capital accounts(and therefore members' tax basis), which will increase our gain on disposition which is a capital gain. But to test this, he's willing to  file twice: initially as capital losses and the amended 1040 as business bad debts. He says(as do other experts I've read) that I'm an investor, not a lender and therefore am not "in the business" of a lender even though I made four separate loans with promissory noteswhich is required to take a bad debt write off. Plus, the LLCs were all funded with no equity, just bank debt and member debt so the debt could be characterized as equity by the IRS. Finally, where on my schedules would I show business bad debts: somewhere on schedule E?

Thanks again.
Arlo
 
Posts: 38
Joined: Thu Jan 16, 2014 11:28 am


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