by Mark Sutton and Sarah Wolters, Plante Moran
Most real estate projects are financed by loans. While businesses often look to banks and other commercial lenders first, it’s still pretty common to see real estate financed by loans from one related company to another, or from an LLC member (or members) to a limited liability company (typically taxed as a partnership). These intercompany loans may satisfy the organization’s short-term need for cash, but they sometimes lead to an unintended negative tax consequence in the long term.
When a borrower defaults on a loan and the lender forgives all or a portion of the loan, tax law treats the amount of the loan that remains unpaid as “cancellation of debt” (COD) income to the borrower. If the borrower is a pass-through entity like a partnership, that “income” is reported to the partners for tax purposes even though no money actually changes hands.
When a default occurs, tax law typically allows the lender to claim a bad debt deduction. However, the character of this loss may limit the amount that the lender may deduct in certain (fairly common) circumstances. So, when a partner or related partnership loans money to another partnership and it subsequently defaults, it’s quite possible that the partner will have to report ordinary COD income that flows through from the default partnership. Meanwhile, the partner’s deduction for the bad debt (directly or flow-through from a lending entity) may be limited under the law because it’s treated as a short-term capital loss.
A quick look at the law
U.S. tax law classifies bad debts into “business” and “non-business,” and the law treats these two classes differently.
A business bad debt is:
- Related to a loan made in the ordinary course of the taxpayer’s trade or business.
- Treated as an “ordinary” deduction.
- Deductible even when the debt is only partially worthless to the extent of the loan impairment.
A nonbusiness bad debt is:
- Related to a loan made outside of the taxpayer’s ordinary trade or business.
- Treated as a short-term capital loss because the debt is related to a deemed investment activity.
- Deductible only when it becomes totally worthless.
COD income is generally treated as ordinary income to the borrower.
If the loan is between two unrelated parties and the lender is in the trade of lending money, the amount of the loan determined to be uncollectable is typically a business bad debt that generates an ordinary deduction for the lender. When the loan is between two related parties, the amount determined to be uncollectable may qualify as business bad debt in some circumstances and nonbusiness bad debt in others. Bad debts arising from loans by corporations are always considered business bad debts, but in the case of a Subchapter S corporation, the loss may be considered a nonbusiness bad debt because this is a pass-through entity for tax purposes.
The law is not quite as clear when it comes to classifying bad debt expenses that arise from a related party loan made by an individual or between partnerships as business or nonbusiness. In a few specific circumstances, courts have indicated that they are open to the argument that losses on a loan like this can be considered business bad debt by the lender. However, the Internal Revenue Service (IRS) almost always seems to conclude that the classification is a nonbusiness debt in these circumstances and that the bad debt expense should be treated as a short-term capital loss. This is because the lender is not considered to have made the loan in the ordinary course of the lender’s trade or business.
First and foremost, the most important thing to remember is that if you’re a partner in a partnership and the business is considering structuring a loan from either a partner or a related entity to the business, consult with a tax advisor about the potential tax ramifications. There may be additional ways to structure the cash infusion to avoid this negative consequence. Depending on facts and circumstances, there may also be case law to support a business bad debt ordinary treatment. If you make the loan without any additional planning and the partnership defaults, you could wind up with ordinary COD income and a corresponding short-term capital loss that is worth considerably less.
Mark Sutton is a partner and Sarah Wolters is a tax manager with Plante Moran, a certified public accounting and business advisory firm with locations in Illinois, Michigan, and Ohio, as well as internationally.