Business Bad Debt Shareholder Loan: How to Deduct Losses on Taxes

When a shareholder lends money to their business, there’s always a risk the company won’t repay it. If the loan becomes uncollectible, shareholders may be able to claim a tax deduction. However, the IRS has strict rules on how these losses can be deducted, making proper classification and documentation essential.

Distinguishing a Loan from Equity

The IRS examines whether a shareholder’s financial contribution is a loan or an equity investment. This distinction determines whether a loss can be deducted as bad debt or treated as a capital loss. A loan establishes a debtor-creditor relationship, meaning the business has a legal obligation to repay. Equity represents ownership, where repayment depends on the company’s financial success.

A properly structured loan includes a written promissory note specifying repayment terms, interest rates, and a fixed schedule. The IRS considers whether the business has made consistent payments—irregular or nonexistent repayments suggest the funds were intended as equity. Charging a reasonable interest rate, in line with the Applicable Federal Rates (AFRs), further supports the classification as a loan.

The company’s financial condition at the time of the transaction is also key. If the business was already struggling and unlikely to repay, the IRS may reclassify the funds as equity. Courts have ruled in cases like Calumet Industries, Inc. v. Commissioner that loans to undercapitalized businesses are more likely to be treated as equity.

Criteria for Worthless Debt

To claim a deduction, the debt must be completely worthless, meaning there is no reasonable expectation of repayment. Partial losses do not qualify. Determining worthlessness involves assessing the company’s financial condition, including bankruptcy filings, insolvency, or ceasing operations with no realistic path to recovery.

A business closing does not automatically render a debt worthless. The IRS expects shareholders to make reasonable efforts to collect, such as sending formal demand letters or pursuing legal action. If the company has no remaining assets or income, these efforts may be futile, but shareholders must demonstrate due diligence.

The deduction must be claimed in the year the debt becomes worthless. Taxpayers must provide objective evidence, such as financial statements or bankruptcy filings, to establish the exact year of worthlessness. Missing this window could result in the IRS disallowing the deduction.

Classification as Business Debt

When a shareholder loan becomes uncollectible, its classification determines whether the loss is deductible as an ordinary business bad debt or a nonbusiness bad debt. Ordinary business bad debts are fully deductible against ordinary income, while nonbusiness bad debts are treated as short-term capital losses, limiting the tax benefit.

For the IRS to recognize a shareholder loan as a business bad debt, the funds must have been lent with a direct connection to the lender’s trade or business. This typically applies when the shareholder is actively engaged in the business and the loan was made to protect or enhance their role in generating income.

The shareholder’s level of involvement also matters. If they work full-time in the company as an officer or key employee and rely on its success for income, the IRS is more likely to accept the loan as business-related. Passive investors with little day-to-day involvement are more likely to have the debt classified as nonbusiness, restricting the deduction.

Deducting the Loss on Individual Taxes

When a shareholder determines a loan to their business is uncollectible and qualifies as a business bad debt, the deduction must be reported on their individual tax return. Business bad debts are treated as ordinary losses, meaning they can offset other income, including wages, dividends, and business profits. The deduction is claimed on Schedule C for sole proprietors or Schedule E for pass-through entities like S corporations or partnerships where the shareholder materially participates.

The deduction is limited to the shareholder’s adjusted basis in the debt. If payments were made before the loan became worthless, only the unpaid balance can be deducted. Any accrued but unpaid interest previously included in taxable income can also be written off. If the deduction results in a net operating loss (NOL), it may be carried forward indefinitely under current tax law to offset future income.

Documentation for Filing

Proper documentation is essential to substantiate a bad debt deduction in case of an IRS audit. The burden of proof falls on the taxpayer to demonstrate the loan was bona fide and became worthless in the year the deduction is claimed.

A well-documented loan includes a signed promissory note detailing repayment terms, interest rates, and a fixed schedule. Evidence of payments before the loan became uncollectible further supports its legitimacy. If the borrower defaulted, records of collection efforts—such as demand letters, legal filings, or communications regarding insolvency—help establish worthlessness. Financial statements, tax returns, or bankruptcy filings showing the company’s inability to repay provide objective evidence. Without sufficient documentation, the IRS may disallow the deduction, reclassify the loan as equity, or impose penalties.

Shareholder Basis Adjustments

When a shareholder claims a bad debt deduction, it affects their basis in the company, impacting future tax reporting. Basis represents the shareholder’s investment in the business and determines the tax consequences of distributions, losses, and stock sales.

If the loan was included in the shareholder’s basis, deducting the bad debt reduces that basis. This is particularly relevant for S corporation shareholders, as their ability to deduct business losses is limited to their basis in stock and loans. If the deduction reduces basis to zero, additional losses may be suspended until basis is restored. For C corporation shareholders, the bad debt deduction does not affect stock basis but may impact overall investment calculations. Keeping accurate records of basis adjustments is necessary for future tax filings and to avoid discrepancies in capital gains or loss calculations when shares are sold.