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.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
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