Bad debt between related parties?

Technical topics regarding tax preparation.
#1
gusser  
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TP was 100% sh in C corp A when he died 5 years ago with no will. Estate hasn't been settled due to greedy family. Corp A had lent $250k over many years to failing Corp B that was owned by TP & surviving spouse 50/50. There are no assets for Corp B and it has no way to pay the funds back to Corp A. How/when does the $250k asset get removed from Corp A's books/tax return? Since the spouse will inherit his 50% of Corp B and will become 50% in Corp A when estate is settled (by law the 2 children split the other 50% of Corp A), this has to be a related party issue. Can a reduction in retained earnings work (non-deductible related party bad debt) along with a corresponding COD income to Corp B? Corp B has enough NOL to eat it up. Or is this somehow a deemed dividend to spouse? Thanks for any feedback.
 

#2
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Are you saying that the bad debt is not deductible because it was made to a related party?
 

#3
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Verytaxing wrote:Are you saying that the bad debt is not deductible because it was made to a related party?


That's what I'm thinking, yes.
 

#4
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Bona fide debt to a related party does not preclude it from being deductible by the lender when the debt is not collectible. It may be closely scrutinized under audit, but there is nothing that precludes it’s deduction under statute.
 

#5
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Would it matter if there was no note, nothing formal, just intent to treat it as a loan (treated that way on both sets of books)?
 

#6
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The "loan" from A to B, given that B is described as "failing" starts out as suspect, and the absence of proper documentation does not help. Note Verytaxing's use of "bona fide". If I were a betting man, I'd bet there is also no record in the corporate minutes, if those even exist.

It's not unlikely that the substance of these facts amounts to a distribution by A to its sole shareholder, a gift by H to W, and a capital contribution by H and W to B. Distributions by C corporations can be dividends.
 

#7
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Yes, it matters a lot. That would certainly be a high hurdle to overcome. Missing all the badges of a bona fide debt doesn’t bode well for the lender when seeking a bad debt deduction. But the reason this fails is lack of a bona fide debt, not the related party issue.
 

#8
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Were A's and B's businesses in some way (other than ownership) related to one another, or were they completely separate/different?

And I just noticed that, while A is a C corp., we are not told whether B is too.
 

#9
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Corp b is also 1120. Same building, similar business. One guy for years
ran it like one empire and didn't need paperwork/lawyers costing him time and money. Old timer. Now he's dead and things are a mess.
 

#10
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You're overthinking this. The parties treated it as a loan, so report it that way. Advise your client of the potential recharacterization on audit and move on.
Steve
 

#11
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I think the 250k should be a dividend from Corp A, and a capital contribution to Corp B.
 

#12
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gatortaxguy wrote:You're overthinking this. The parties treated it as a loan, so report it that way. Advise your client of the potential recharacterization on audit and move on.

I think the potential recharacterization on audit demonstrates that we're not overthinking this. The IRS and the courts can and do recharacterize things that are called loans as dividends.

But here's why I'm interested in jumping into the discussion: So let's say it's a dividend. When did that dividend happen? It sounds like it was more than 5 years ago. So the tax consequences of a dividend, of course, are that the shareholder is supposed to pay tax on it in the year received (assuming the shareholder isn't a C corp, etc.). So the deceased individual taxpayer should have reported it as dividend income and didn't. And now it's past the statute of limitations (probably even past the 6-year statute for gross income underreported by 25%), so he won't pay any tax on it.

Therefore, wouldn't dividend treatment at this point be the favorable interpretation of the facts? And you can tell the IRS "nanner-nanner-boo-boo" (not sure if there's an official attachment for that). Right?

How would you handle this (transactions from 5+ years ago that were recorded as a loan but should have been a dividend) if the corporation were still operating and the shareholder were still alive?
 

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No difference.
Steve
 

#14
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Applying the equitable principle of the duty of consistency, IRS might just find a way to tax the distribution in the year of write-off of the loan. https://www.thetaxadviser.com/issues/20 ... tency.html

I could also see IRS imputing nterest between the corps., thus using up some NOL of B. Maybe some 1099 penalties too?

But surely I'd still take the return position that it was a loan. And because these are C corps. and in related, maybe even co-dependent, businesses, it was a business loan. Ordinary deduction, COD income, use NOL.
 

#15
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gatortaxguy wrote:You're overthinking this. The parties treated it as a loan, so report it that way. Advise your client of the potential recharacterization on audit and move on.


That's what I will probably do but taking a 250k deduction for bad debt will cause a large NOL. I'd rather not waive any large flags.
 

#16
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beardenjv wrote:
gatortaxguy wrote:You're overthinking this. The parties treated it as a loan, so report it that way. Advise your client of the potential recharacterization on audit and move on.

I think the potential recharacterization on audit demonstrates that we're not overthinking this. The IRS and the courts can and do recharacterize things that are called loans as dividends.

But here's why I'm interested in jumping into the discussion: So let's say it's a dividend. When did that dividend happen? It sounds like it was more than 5 years ago. So the tax consequences of a dividend, of course, are that the shareholder is supposed to pay tax on it in the year received (assuming the shareholder isn't a C corp, etc.). So the deceased individual taxpayer should have reported it as dividend income and didn't. And now it's past the statute of limitations (probably even past the 6-year statute for gross income underreported by 25%), so he won't pay any tax on it.

Therefore, wouldn't dividend treatment at this point be the favorable interpretation of the facts? And you can tell the IRS "nanner-nanner-boo-boo" (not sure if there's an official attachment for that). Right?

How would you handle this (transactions from 5+ years ago that were recorded as a loan but should have been a dividend) if the corporation were still operating and the shareholder were still alive?


If you treat it presently as a dividend, no 1099-DIV, no reporting?
 

#17
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Thanks, Nilodop, that makes sense. I asked because we inherited a client a while back with a similar situation (but still operating), and we ended up going with the duty of consistency but without fully understanding how that fits in the tax law. Thanks for that article, very helpful.

Hopefully the NOL will make it all not matter too much in this situation.

But let's suppose that the facts were a bit different, and that there's no NOL and the loan was actually written off years ago, and they failed to record the income in that year due to a mistake. Would you say that the failure to write off the loan for A and recognize income for B would be a representation of fact (under the First Element in the article)?
 

#18
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gusser wrote:taking a 250k deduction for bad debt will cause a large NOL. I'd rather not waive any large flags.

You're not obligated to take a deduction for A, even if B reports income. You don't have to take deductions for deductible expenses/losses you don't want to deduct. You could treat it as a nondeductible expense, which I doubt would score high on the IRS DIF score.

gusser wrote:If you treat it presently as a dividend, no 1099-DIV, no reporting?

If you treat it as a 2022 dividend, then a 2022 Form 1099-DIV would be required. If you treat it as a dividend in a previous year (like over 5 years ago), I wouldn't bother filing a Form 1099-DIV; however, this may not be legal, as Nilodop pointed out.
 


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