8759 / Is a bad debt deduction permitted when a loan made between related parties becomes worthless?

A bad debt deduction may still be allowed in situations where the bad debt results from a loan made between related parties. The analysis of whether a worthless loan made between related parties gives rise to an allowable bad debt deduction is not the same as the analysis undertaken under IRC Section 267, however, which disallows certain losses on sales between related parties.¹

Intrafamily transactions are subject to rigid scrutiny, and transfers between two spouses are presumed to be gifts. However, this presumption may be rebutted by an affirmative showing that there existed at the time of the transaction a real expectation of repayment and intent to enforce the collection of the indebtedness.²

The relevant inquiry in the bad debt context is whether the transaction was a valid loan or was instead a gift made between related parties. In making the determination, the courts examine all of the relevant facts and circumstances of the specific case.³

In connection with this facts and circumstances inquiry, it is important that both parties must intend and agree to treat the transaction as a loan, rather than as a disguised gift. Proper documentation of the transaction, while not strictly required, is helpful in proving the parties’ intentions.⁴ Regardless of whether the loan would have been extended had the parties not been related, the deduction should be sustained if, at the time the loan is made, there is a true intention amongst the parties that the debt will eventually be repaid.⁵ See also Treasury Regulation Section 1.262-1(c)(4), which cites the IRC Section 166 bad debt deduction as one deduction that may be allowable despite the personal nature of the transaction.

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Planning Point: In the context of related-party transactions, it is important to note that the worthless debt will likely be classified as a nonbusiness debt. Completely worthless nonbusiness bad debts can only be claimed as short-term capital losses (see Q 8648).⁶

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