Creditor’s Loss Treatment, Business and Non-business Bad Debts, U.S. vs Generes

Creditor’s Loss Treatment Overview

creditors loss treatment business and nonbusiness bad debt

When things go downhill for a corporation, what happens is very different for a creditor versus an equity holder. If the creditor is a corporation, the bad debt that results is an ordinary deduction. But, if the creditor is something other than a corporation, then the bad debt can be treated two ways: as an ordinary deduction or as a short-term capital loss.

What makes the difference is the type of loan it was. If it was a business bad debt, the investor gets ordinary loss treatment, but if it turns out to be non-business bad debt, then the loss will be given short-term capital loss treatment.

Whether or not something is business bad debt or non-business bad debt can be hard to define sometimes. One of the ways to determine this is whether or not the corporation is in the business of loaning money… If it is, then it’s reasonable to assume it will be treated as business bad debt.

Another consideration is if a person is loaning money to their employer so that the business can continue and that they can continue to receive their salary. This is obviously rare, so in most cases an investor loaning money to a corporation that fails will be considered non-business bad debt, and will be treated as a short-term capital loss. This is less than ideal since only $3,000 a year can be deducted unless the investor has significant capital gains that the loss can be offset against.

United States vs. Generes Creditor’s Loss Treatment Case:

  1. In 1954, Generes and his son-in-law Kelly formed a construction company that was to engage in construction projects
  2. Generes owned 44% of the stock and was the president of the corporation and also received an annual salary of $12,000
  3. Generes loaned money to the corporation once in awhile and acted as guarantor on several of these corporate loans
  4. In 1962 the company underbid two projects
  5. Generes ended up paying the bonding company over $162,000 because he has indemnified the bonding company
  6. Generes loaned the business another $158,000 to keep the business alive
  7. The corporation went into receivership and Generes was unable to his money
  8. On the 1962 tax return, Generes claimed a nonbusiness bad debt loss for the $158 loan and claimed a business bad debt loss for the $162k paid to indemnify the bonding company
  9. Generes testified that his sole motive in signing the indemnity agreement was to protect his salary of $12k/year

The Issue: What was the real reason for entering into the indemnification agreement and paying the bonding company $162k?

The Decision: The Supreme Court ruled that the dominate reason was what controls, and they deemed the dominant reason to be that Generes was looking to protect his equity, and not his salary. So the $162k was given short-term capital loss treatment.

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