Volume 5 Issue 2008

Laura’s unincorporated business was struggling. But she was hopeful she could turn things around if she pumped in some of her own cash. Unfortunately, six months and $30,000 later, the company’s financial situation hadn’t improved, and Laura decided to close the business.

The money Laura put into the business was used to cover payroll, buy supplies, and pay utility bills — all bona fide business expenses. Since the business can’t pay her back, can she deduct the $30,000 as a bad business debt?

Bona Fide Debt?

A bad debt is tax deductible in the year the debt becomes worthless — but only if it is a bona fide debt and not a contribution to capital. What does that mean?

• There must be a creditor-debtor relationship between the lender and the borrower.

• There must be an enforceable obligation for the debt to be repaid.

• The payment amount must be fixed or determinable.

So, if Laura hopes to deduct the $30,000, she will need proof that the money she put into the business was indeed a loan and that there was an obligation for the company to repay the money under a loan agreement.

Or Contribution to Capital?

If Laura doesn’t have proof that she loaned the business the money, then her outlay is generally considered a contribution to capital — and, therefore, is not tax deductible as a business bad debt.