SOLUTIONS TO PROBLEM MATERIALS
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.
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 contribution to capital, the
issue is whether the advance is a business or nonbusiness bad debt. The distinction is significant because business
bad debts can be deducted without limitations, while the deduction for nonbusiness bad debts as a short-term capital
loss is limited to $3,000 plus the taxpayer’s capital gains. Based on the decision in
loan to a
corporation is normally not considered a business debt because it does not arise in the course of the taxpayer’s trade
or business. Only a taxpayer who can show that he or she is in the business of organizing, promoting, and financing
businesses will be able to salvage ordinary loss treatment.
On the other hand, if F is an
for the corporation, 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. If protecting
his job was the reason for making the loan, F must demonstrate that it was the “primary and dominant” motive. One of
the most significant factors in making this determination is the size of the loan in relation to the salary that F is trying to
There is no deduction in this case for two reasons. First, no deduction is allowed because there is no valid debt. If the
obligation to pay is contingent on the occurrence of an event (such as meeting a certain level of sales) and such event
does not occur, there is no valid debt. Moreover, in this case, the taxpayer has no basis in the debt. Thus, no matter
how badly the taxpayer feels about not receiving the bonus, he can find no relief from the tax law.