Debts owed to a taxpayer which become worthless are deductible if:
(1) incurred in the taxpayer’s trade or business or,
(2) created or acquired in such trade or business.
Otherwise, bad debts are treated as short-term capital losses and subject to the limitations on deductibility of capital losses discussed below.
Issues relating to bad debts usually arise in connection with investments in closely-held businesses. The disputes center around whether the loan or advance to such businesses was motivated by investment motivations or to protect the taxpayer’s job. These issues are difficult and professional advice should be sought prior to making loans of this nature as other tax-advantageous routes may be available.
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