Tax & Business Insights

Does a Bankrupt Debtor = A Bad Debt Deduction?

Volume 24 Issue 5 -- September/October 2012

In recent years many taxpayers have held debts owed by persons or companies that file bankruptcy petitions.

It is apparently widely assumed by many tax practitioners that when a debtor files a bankruptcy petition this means that the debt automatically becomes worthless and can be deducted as a bad debt. While there is a certain intuitive appeal to this view, it is not the law.

IRC § 166(a)(1) allows a deduction for debts that become worthless within the taxable year. The amount of the deduction is equal to the taxpayer’s basis in the debt.

Neither the Code nor the  Regulations precisely define when a debt becomes “worthless.” The Regulations speak of “evidence of worthlessness,” but do not provide a comprehensive definition of when that occurs.

The Regulations do suggest that a debt is worthless and uncollectible if a legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment.

Thus, a taxpayer must exhaust all the usual reasonable means of collection to prove that a debt is worthless. Usually, this would include filing a claim in bankruptcy. Mere opinions or assertions by the taxpayer or even by an attorney will not be sufficient.

Note that the question here has two components — establishing that the debt is worthless and establishing when it became worthless. A taxpayer must be prepared to prove both components. In other words, it is not enough to show that a debt is worthless; the taxpayer must also prove that it first became worthless in the year in which the deduction is taken.

The IRS frequently challenges bad debt deductions on the ground that the debt became worthless in a year different from that claimed by the taxpayer.

Some courts look to “reasonable business judgment” as a standard for determining when a debt has become worthless, but this is hardly a bright-line test.

At most, a debtor’s filing of a petition in bankruptcy may be an indication of worthlessness, but by itself it will not prove either the fact of worthlessness or the time that the debt became worthless.

How can that be, some may ask?

One reason is that some debts are not  dischargeable in bankruptcy. Various types of obligations, such as obligations based on fraud as well as obligations of support, cannot be discharged in bankruptcy.

Even if a debt is theoretically dischargeable, there is often some possibility of some payment at the time of the bankruptcy filing. This is particularly true in bankruptcies under Chapter 11 and Chapter 13 which are in the nature of reorganizations. In such cases, a payment plan will be proposed.

Also it makes a difference if the debt is secured or unsecured. While the filing of a bankruptcy petition often does not bode well for payment of an unsecured debt, if the debt is secured there is a greater likelihood of at least partial repayment.

Similarly, not all unsecured debts are necessarily equal in bankruptcy. Some debts may be given “preferred” status, meaning that they will be paid before other unpreferred claims.

IRS Regulations indicate that the filing of a bankruptcy petition is generally an indication of worthlessness of at least a part of an unsecured and unpreferred debt, but non-business debts are not deductible until they are wholly worthless.

The courts have suggested that unless the net assets of the bankruptcy estate are clearly insufficient to satisfy the debt, the filing of the bankruptcy petition will not prove worthlessness.

In many cases, it will not be possible to make that determination when the bankruptcy petition is first filed. Even in petitions filed under Chapter 7 (liquidation), the likelihood of a payout to even unsecured creditors will depend upon the number and the amount of the claims allowed by the bankruptcy court as well as the actions of other creditors. As a result, it will often not be possible to know what any given creditor is likely to receive at least until a payment schedule has been proposed.

Of course, if the bankrupt person has no assets, then complete non-payment is rather more likely.

As noted above, the taxpayer must prove when the debt became worthless. A debt can become worthless long before a hopeless insolvent debtor files the bankruptcy petition or, in some cases much later, as when a final discharge of the debt in bankruptcy occurs.

If you have questions about bad debt deductions or similar issues, please contact Tax & Business Professionals.


Copyright 2012
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