Could an employee-shareholder deduct loans that became worthless when his S corporation closed?

Subject

Employee-shareholder's worthless corporate loans were allowed as business debt

Plain-English summary

Virginia allowed the bad-debt deduction and abated the assessment. The husband was both an employee and shareholder of an S corporation and lent it money to keep operating. The loans became worthless when the company closed in 2013.

A shareholder loan is a business bad debt only when the dominant motive is protecting the taxpayer's trade or business—here, employment—rather than the investment. That motive is factual and can depend on salary, investment size, and other income.

Virginia said it lacked clear evidence that the husband's dominant motive was investment-related. It therefore allowed the itemized deduction reflected on the federal return.

Result: the assessment was abated. Any later IRS change affecting federal taxable income had to be reported to Virginia.

What this means for you

• Document why each shareholder loan was made.
• Separate employment-protection motives from investment-protection motives.
• Preserve salary, ownership, capitalization, and other-income evidence.
• Report any later federal adjustment to Virginia.

Common questions

Q: Are all shareholder loans business bad debts?

A: No. The taxpayer's dominant motive must be business-related.

Q: Did Virginia conclusively find an employment motive?

A: It allowed the deduction because it lacked clear evidence that investment motive was dominant.

Citations and references

• Va. Code §§ 58.1-219, 58.1-301, and 58.1-322(D)(1); IRC § 166; Treas. Reg. § 1.166-5(b).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-184

Original ruling text

September 24, 2015

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek correction of the individual income tax assessment issued to your clients, * (the "Taxpayers"), for the taxable year ended December 31, 2013.

FACTS

The Taxpayers, a husband and a wife, filed a Virginia resident individual income tax return for the 2013 taxable year and deducted their federal itemized deductions, including a bad debt deduction for loans made to * (the "Corporation"), a Subchapter S corporation. The husband was an officer and shareholder of the Corporation. The husband made a series of loans to it in 2011 and 2012. In 2013, the Corporation ceased operations and the debt became uncollectible. Under audit, the Department denied the deduction on the basis that the loan was made to a corporation. The Taxpayers appeal the assessment resulting from the denial of the deduction, contending that the deduction was allowable because the bad debt was business debt.

DETERMINATION

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia conforms to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI).

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust FAGI where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Va. Code § 58.1-219. Virginia Code § 58.1-322 D 1 allows a taxpayer to deduct from his Virginia adjusted gross income the amount allowed for itemized deductions for federal income tax purposes.

Generally, bad debts are deductible in the taxable year in which they become worthless. See IRC § 166(a). The debt, however, must be a business debt, defined as a debt created or acquired in connection with a trade or business of the taxpayer or a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. See IRC § 166(d). Treas. Reg. § 1.66-5(b) requires that in order for a taxpayer to deduct losses as a business bad debt, the taxpayer must show that the bad debt loss is "proximately related" to the conduct of a trade or business, or that the debt was created in the course of trade or business.

Whether the bad debt loss is proximately related to the conduct of a trade or business depends on whether the taxpayer's "dominant motivation" underlying the transaction at issue is business or investment-related. See U.S. v. Generes , 405 U.S. 93, 103 (1972). An employee-shareholder may make loans to his company both to protect his investment and his status as an employee; however, the dominant purpose of the loans must be to protect his status as an employee for the bad debt to be deductible. See id . at 104. Ultimately, the taxpayer's dominant purpose is a question of fact. Id . Courts that have examined the issue tend to focus on the size of the taxpayer's investment, the size of the taxpayer's after-tax salary, and the taxpayer's additional sources of income. See Litwin v. U.S. , 983 F.2d 997, 1000 (10 th Cir. 1993). A court is more likely to find that a taxpayer made a non-deductible loan where the taxpayer's investment is relatively large, the taxpayer's salary is relatively small, and the taxpayer's other sources of income are relatively large. Id .

In this case, the husband was an employee and shareholder of the Corporation. When the Corporation began experiencing financial difficulties in 2011, the husband made several loans to the Corporation to keep it operating. When the Corporation closed in 2013, the loans became uncollectible. The Department does not have clear evidence that the husband's dominant purpose in making such loans was investment, rather than business-related. Therefore, the deduction will be allowed and the assessment abated.

The Taxpayers should be aware that if they are audited by the Internal Revenue Service and an adjustment is made to the bad debt deduction or anything else in such a way that it affects their federal taxable income, they must report such change or correction within one year of the final determination of such change or correction by filing an amended return with the Department. See Va. Code § 58.1-311.

The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department's web site. If you have any q uestions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns
Tax Commissioner

AR/1-6029520543.M