Hi All

We just dissolved a 3 partner S-corp. All shareholder loans to the company could not be repaid and were forgiven; this produced COD income for each shareholder.

My question is: How can the bad SH loans be deducted on our personal returns? The loans were never officially documented as such, and our then accountant never generated 1099's for imputed interest. In my case, there are both debt and equity basis plus no carry-forward losses from prior years to offset the COD. I am not sure if I can take a personal deduction for my "bad" loan as ordinary income (Sch E?) or if it must be considered a capital loss (Sch D?) subject to the $3K limitation. Obviously, deducting as ordinary income would be much better. I am also not sure how stock basis affects the calculation.

Secondly, where exactly (form/line numbers) would the individual bad loan deduction info be entered on both the 1120S (K-1) and personal returns?

Thanks

My question is: How can the bad SH loans be deducted on our personal returns? The loans were never officially documented as such, and our then accountant never generated 1099's for imputed interest. In my case, there are both debt and equity basis plus no carry-forward losses from prior years to offset the COD..=======>>then you need to prove it is aloan to your S corp; in general, tax law requires you to charge / record / report interest if the amount of loan to S corp when the amt is over $ 10K. In this case you need to have a written contract for the loan between you and your corp and the schedule of the repayments should be similar to a commercial loan ; the interest rate charged must be at least as much as the applicable federal rate determined monthly by the IRS ;if not, the irs may impute interest unless the loan amount is less than $10K. I guess I do not think that you can claim biz bad debt: To be considered a bona fide debt, the loan must meet demanding standards, especially when the shareholder is considered a related party.in general biz bad debts arise when there was a bona fide debtor-creditor relationship that implies that the borrower has a legal obligation to pay back the loan or to pay for the goods or services. Any loan agreement should stipulate at least the loan amount, interest rate, maturity date, and repayment schedule. Fo re xample, loan/money given to your S corp should be evidenced as a loan with a loan agreement; otherwise, it may be treated as a nondeductible contribution of capital. As said above, true creditor-debtor relationship must exist between the taxpayer and the borrower, the S corp. Since you are related to the borrower, S corp, then the IRS may treat the loan as a gift / perhaps APIC rather than as a true loan. To claim the bad debt deduction, the transaction must have been intended as a loan and not as a gift. You need to be careful about the use of SH bad debt to capitalize a business because the failure of the corp to repay can cause problems for both you and the corp. As a PTE, one of these problems is when the company is dissolved without repaying the debt . tax law provides an exemption from recognition of C.O.D. income to bankrupt debtors and to insolvent debtors to the extent of their insolvency. The insolvency exemption for yiour S corp is determined at the company level, and C.O.D. income does not pass through to owners of the corp. Instead, the tax attributes of the corporation are reduced .The problem for SH is that the reduction in basis can result in the recognition of future income at the corporate level that would pass through to them even though there is no cash flow to make distributions. A possible solution to S corp debt that cannot be repaid is ;tax law ,in appropriate circumstances, would enable owners to contribute the indebtedness to the corporation without recognition of income. However, it is significantly limited however since an indebtedness contributed to an insolvent corp must be treated as C.O.D. income to the extent of the insolvency.







I am not sure if I can take a personal deduction for my "bad" loan as ordinary income (Sch E?) or if it must be considered a capital loss (Sch D?) subject to the $3K limitation. Obviously, deducting as ordinary income would be much better. I am also not sure how stock basis affects the calculation Secondly, where exactly (form/line numbers) would the individual bad loan deduction info be entered on both the 1120S (K-1) and personal returns?==========>>>>>> as mentioned above.
Aslongas the bad debt is lawful Sh biz bad debt , then, the biz bad debt would be reported on Form 4797 as an ordinary loss.

Thank you so much for your reply. As I suspected, the loans do not conform to the proper conditions needed for deduction as ordinary income on form 4797. Would that have been 4797 Part I, as the loans were made well over a year ago?

Might it instead be reported as a capital loss either on Form 8949 or SchD Line 12? If so, is the stock basis used in the calculation?

As for the Insolvency approach--On the "Day Before" dissolution, the only other outstanding corporate debt was a non-shareholder loan made by an unrelated individual. This loan will also never be repaid so is also being forgiven, thereby adding even more to COD income.

This hardly seems fair. Not only do I lose all the money invested in the company, but have to pay tax on it as well!

Best regards

Thank you so much for your reply. As I suspected, the loans do not conform to the proper conditions needed for deduction as ordinary income on form 4797. Would that have been 4797 Part I, as the loans were made well over a year ago?===>>Sorry it is my bad; Bad debts of a corp are not always business bad debts but if you are in the business of lending money to others, then,you may treat it as an ordinary loss. Bad Loans to Corps are treated as Non-Business Bad Debt Losses as capital losses. So,the loss on the loan you made to your S corp was probably a capital loss. I guess you think that It is not a sch D loss because it was not capital and you believe it should be entered on Form 4797 . however, it is not rreported on form 4797; A nonbusiness bad debt is reported as a short-term capital loss on Form 8949 ,Part 1, line 1. You need to enter the name of the debtor and "bad debt statement attached" in column (a) and your basis in the bad debt in column (e) and enter zero in column (d). IN GENERAL, YOU NEED TO Show any ordinary gain/losses in Part II OF F 4797. however,If the IRS questions whetherthe loan is a biz debt, you may end up having to explain your motives for the loan. If, like many S-corp owners, you work for the company, you can argue you made the loan to keep yourself employed, which makes it a business debt.



Might it instead be reported as a capital loss either on Form 8949 or SchD Line 12? If so, is the stock basis used in the calculation?==>>Yes as mentioned above. To claim a loss you have to subtract from your basis either form your stock or loan basis. The stock basis is the amount of cash you've invested; the debt basis is the total loans you've made; so,Your stock basis is decreased first by all deductible losses / deductions reported on your Sch K-1 .


As for the Insolvency approach--On the "Day Before" dissolution, the only other outstanding corporate debt was a non-shareholder loan made by an unrelated individual. This loan will also never be repaid so is also being forgiven, thereby adding even more to COD income.==>>as
the non shareholder doesn't work for the corp and made the loan to shore up his/her previous investments, the IRS'd regard that as a non-business debt claimed on Sch D;
Nonbiz bad debts are treated as stcl. Such losses are first deducted from your stcg, if any. If your net short-term losses exceed your short-term gains, your net short-term capital losses are then deducted from your total long-term capital gains for the year. If your net short-term losses exceed the long-term gains, the excess short-term loss is deductible against up to $3k of your other income. Any amount remaining can be carried forward and deducted in future years indefinitely. Since a S-Corp is a pass thru entity. This is a case where the individual would have a bad debt and income ,debt forgiven, pass thur the S-corp.









This hardly seems fair. Not only do I lose all the money invested in the company, but have to pay tax on it as well!=>Agreed. as many say tax law does not have to be quite logical.

Thanks again for responding-This is a great discourse. I think we are getting closer to the truth.

I think my bad debt can be divided into two parts. The company was initially set up with a high SH loan/stock ratio. This was followed by a loan to equity conversion - leaving me a residual loan basis under $10K. 1099-INTs were issued to shareholders at that time for accrued imputed interest. I believe that portion could be considered Bad Biz Debt for Ordinary Loss on form 4797.
Since the remaining loans were made afterwards and not well documented, they would probably be considered capital loss.

So, using accumulated basis, how do we figure this capital loss? My accumulated basis consists of both stock (result from loan->equity conversion plus annual adjustments) and loan (money directly paid in the company's behalf). The accumulated loan basis is what I consider to be the bad loan. To figure the capital loss for this activity, what is the exact relationship between the accumulated stock and loan basis?
There are no K-1 losses to deduct this year due to all the COD income.

BTW--I was aware of the $3K capital loss limit, so any capital loss will have to be carried forward. That's why we want it to be ordinary loss.

Best regards

I think my bad debt can be divided into two parts. The company was initially set up with a high SH loan/stock ratio. This was followed by a loan to equity conversion - leaving me a residual loan basis under $10K. 1099-INTs were issued to shareholders at that time for accrued imputed interest. I believe that portion could be considered Bad Biz Debt for Ordinary Loss on form 4797.===>> As said,you can claim bad biz debt on f4797 ONLY aslongas you are in the business of lending money to others, then,you thrn can treat it as an ordinary loss. As said ? unless you are in the business of being a lender, your bad debt is considered a short-term capital loss. You can use the loss to offset any capital gains you have in the year that the debt became worthless. If your loss exceeds your gain, you get the standard $3,000 deduction against noncapital gain income. Any unused loss carries forward as short-term capital loss.? other examples of biz bad debts are; biz bad debts (aslongas previously included in income):loans to clients and suppliers; credit sales to customers, or biz loan guarantees. So, f 4797 is inappropriate unless the SH held the note receivable as a biz asset under code sec 1231 biz asset, rather he held it under code sec. 1221 , SH capital asset. A code sec. 1221 asset can be held for business and still not be used in a business with the disposition therefore being required to be reported on form 4797.my logic as mentioned previously,when the IRS questions whetherthe loan is a biz debt, you may end up having to explain your motives for the loan. If, like many S-corp owners, you work for the company, you can argue you made the loan to keep yourself employed, which makes it a business debt.


Since the remaining loans were made afterwards and not well documented, they would probably be considered capital loss.==>>>as mentioned above .

So, using accumulated basis, how do we figure this capital loss? My accumulated basis consists of both stock (result from loan->equity conversion plus annual adjustments) and loan (money directly paid in the company's behalf). The accumulated loan basis is what I consider to be the bad loan. To figure the capital loss for this activity, what is the exact relationship between the accumulated stock and loan basis?
There are no K-1 losses to deduct this year due to all the COD income.==>> thhe cod income as "Other Income" on page 1of 1120s.form 982 ssays I guess it depends however, to the extent the S Corp was Illiquid you may not need to recognize income for the debt relief, if the debt relief is non-taxable income, you may have to reduce certain tax attributes;if it is taxable as other income, then, as book-tax difference on sch m1 of 1120s if excluded due to insolvency, 982 and attribute reduction as appropriate.

For a SH, Losses /deductions first reduce Sh?s inside/outside bases, stock basis. After stock basis has been reduced to zero, remaining loss amounts are applied against debt basis, I mean remaining loan basis if there is.however, Debt /loanbasis is not reduced by passthrough losses/ deductions aslongas the debt has been satisfied, disposed of, or forgiven during the S corp?s tax year .your your tax basis, stock basis plus loan basis is usually reduced in the Stock basis first, but not below zero and then the loan basis next, but not below zero.


BTW--I was aware of the $3K capital loss limit, so any capital loss will have to be carried forward. That's why we want it to be ordinary loss.====> this is what all TPs want to be treated as biz ordinary losses.

Thank you so much for your patience.

To summarize then:
An active Shareholder in an S corp generally cannot claim Ordinary Losses for a bad (forgiven) SH loan to the company upon dissolution, even if the loan has been documented as such. Instead, the loss is considered capital loss on Sch D. Only professional money lenders can claim bad loan loss as "ordinary" on form 4797.

The exception might be if the SH loan was made to insure continued employment, or in my case, the viability and continued existence of the corporation itself. I believe this would apply here, especially for the portion of the loan basis that was documented.

The capital loss reported would be the sum of both accumulated Stock and Loan basis (minus any loss considered ordinary), unaffected by COD income from the cancelled debt. This short term loss deduction is limited to $3k, carried forward annually.

QUESTION: Doesn't ordinary gain or loss often get reported on Sch E, line 28, and might that apply here?

Best regards