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FTax SM_ch10_p001-014

2011 Federal Taxation (with H&R BLOCK At Home(TM) Tax Preparation Software CD-ROM)

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* C HAPTER T EN * CERTAIN BUSINESS DEDUCTIONS AND LOSSES SOLUTIONS TO PROBLEM MATERIALS DISCUSSION QUESTIONS 10-1 The issue in this situation is whether the loan will be classified as a business or nonbusiness bad debt. The distinction is significant because business bad debts can be deducted without limitation while the deduction for nonbusiness bad debts is limited to $3,000 annually as a short-term capital loss. Normally, a shareholder ' s loan to a corporation is not considered a business debt because it does not arise in the course of the taxpayer ' s trade or business. However, since R is in the business of being an employee for XYZ, the loan might be considered a business debt if he is able to establish that the primary motive for the loan was protection of his job rather than his investment in XYZ. (See Example 1, p. 10-3, and § 166.) 10-2 A cash basis taxpayer may deduct bad debts only if he has a basis in the debt. Because cash basis taxpayers do not include income until it is received, they normally do not have a basis for debt. If the cash basis taxpayer accepted a note for payment, he would be entitled to a bad debt deduction, since the note is equivalent to cash and the related income would have been included. An accrual basis taxpayer may deduct bad debts if the item was included in their income previously. An accrual basis taxpayer may not use the reserve method to account for bad debts. Instead, accrual basis taxpayers can deduct a bad debt only when it becomes worthless (i.e., use the specific charge-off or direct write-off method). (See Example 3 and p. 10-5.) 10-3 a. The treatment of shareholder advances that become worthless is an extremely important topic because of the restrictions that may be imposed on the taxpayer ' s deduction (e.g., at worst, the taxpayer ' s deduction is $3,000 a year). For this reason, it is incumbent on the practitioner to make a client aware of the tax ramifications that result if the loans become worthless, as well as any planning opportunities available to minimize the problem.
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The first problem presented by a shareholder advance is determining whether in fact there was a bad debt. Advances to a closely held corporation that are not repaid may be treated as contributions to capital. In such case, the basis of the taxpayer ' s stock would be increased, and thus would increase the shareholder ' s capital loss when the stock is sold or when it becomes worthless. No loss would be available until there is a disposition of the stock. It should be noted that contributions to capital do not have the effect of increasing the basis of § 1244 stock (i.e., they are not eligible for § 1244 treatment unless § 1244 stock is issued for the contribution). Consequently, the shareholder is prohibited from obtaining ordinary loss treatment for unpaid advances through § 1244. If the taxpayer can demonstrate that the advances were in fact a loan rather than a
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