Common Schedule M-1 adjustments. – Free Online Library

Schedule M-1, Reconciliation of Income (Loss) per Books With Income

per Return, provides a reconciliation between book income and taxable

income on corporate and partnership returns. New practitioners may find

it difficult to understand Schedule M-1; by learning a few concepts, it

may cease to seem like a mystery.


Schedule M-1 adjustments are based on the taxpayer’s method of

accounting. Generally, Sec. 446 requires taxable income to be computed

under the same method of accounting as the taxpayer uses for its books.

For cash-method taxpayers, income is included in gross income when

payment is actually or constructively received; deductions are allowable

when payment is made. Under Sec. 461(h)(1) and (4), accrual-method

taxpayers record revenue and expenses when all three of the following

have occurred: (1) all events have occurred that establish the fact of

the transaction; (2) the amount of the transaction can be determined

with reasonable accuracy; and (3) economic performance has occurred.

Sec. 461(h)(3) provides a recurring-item exception for the economic

performance test. An item is treated as incurred during the tax year if

all events with respect to the item have been met; economic performance

occurs within the shorter of(1) a reasonable period or (2) 8 1/2 months

after the close of the tax year; the item is recurring in nature; and it

is either not a material item or the accrual in the tax year provides a

better matching of income and expenses.

It is important to understand how book income was determined before

adjusting it to arrive at taxable income. The following list describes

and illustrates common Schedule M-1 adjustments.

Accrued Compensation and Benefits

When an accrual-method taxpayer accrues expenses related to a plan,

method or arrangement (i.e., salary, vacation, commissions and

management fees), these amounts will ordinarily not be deductible for

income tax purposes and must be added back to arrive at taxable income

on Schedule M-1. However, Temp. Regs. Sec. 1.404(b)-1T, Q&A-2,

provides an exception if these amounts are paid to employees within 2

1/2 months of the end of the tax year.

Example 1: X Corp. accrued $20,000 of bonus compensation earned by

employees for the tax year ended Dec. 31, 2004. By March 15, 2005, X

paid $12,000 of these bonuses. Because $12,000 was paid out during the 2

1/2 months following the end of X’s tax year, it is deductible on

X’s 2004 return; the $8,000 not paid must be added back in

computing taxable income and will be deductible in the year paid.


In general, Sec. 461(h)(4) disallows a deduction for a reserve

account, because the liability cannot be determined with reasonable

accuracy, nor have all the events occurred to establish the liability.

For example, bad debt expense can be deducted from taxable income only

if a debt becomes worthless in whole or in part during the tax year, the

amount of the loss can be determined with reasonable accuracy and the

debt has been written off or down for book purposes in an amount at

least equal to the deduction claimed. Noncorporate taxpayers cannot

deduct a partially worthless nonbusiness bad debt.

Example 2: Q Corp.’s Dec. 31, 2004 income statement reflected

a $13,000 bad debt expense. Its balance sheet for that date reported a

$10,000 net increase in allowance for doubtful accounts. Q also wrote

off a $3,000 worthless receivable from a previous year. The $10,000 bad

debt expense relating to the increase in allowance for doubtful accounts

is not deductible and must be added back to book income on Schedule M-1.

However, the $3,000 writeoff for the worthless receivable is deductible.

Thus, although book income reflects bad debt expense of $13,000, taxable

income will be reduced only by $3,000, resulting in a $10,000 Schedule

M-1 item.

Tax Accrual

Generally under Sec. 461, an accrual-method taxpayer cannot deduct

taxes until economic performance has occurred (i.e., until the taxpayer

has paid the taxes). However, there are a few exceptions. Under Kegs.

Sec. 1.461-1(c), an accrual-basis taxpayer may elect to ratably accrue any real property tax related to a definite period. The election must be

made on the return for the first tax year in which the taxpayer incurs

the taxes. Also, the recurring-item exception may apply to allow a

taxpayer to deduct taxes even when the economic performance test has not

been met. If this exception applies, a taxpayer can deduct a tax when

all the events have occurred that fix the amount and the liability to

pay, even if payment may not be due until a later date; see Kegs. Sec.


Example 3: During 2004, B Corp. made $10,000 in state estimated tax payments and booked them as state tax expense. While it generally

“trues up” its prior-year state tax expense by adjusting it

for the current year, this was not required for 2003 taxes. After

B’s 2004 financial statements were issued, its CPA prepared its

2004 state returns and determined that B’s actual state tax was

$25,000, leaving B with a $15,000 balance due. Because state tax is a

recurring item, it may be accrued and deducted if paid within 8 1/2

months of the year-end. Thus, B may deduct an additional $15,000 from

book income on Schedule M-1 for the 2004 tax year (even though state tax

expense for books is only $10,000), as long as it paid all state tax due

by Sept. 15, 2005.

Capital Losses

Under Sec. 1211 (a), a C corporation may only use its capital

losses to offset capital gains. The excess capital losses may be carried

back or forward to a year in which the company has excess capital gain.

All excess capital losses in excess of capital gains in the tax year

must be added back to arrive at taxable income on Schedule M-1.

Similarly, capital losses carryovers used in the current year are a

Schedule M-1 item.


Sec. 274(n)(1) limits the deduction for meals and entertainment

(M&E) to 50% of the amount normally deductible. However, M&E

expenses are not limited if they are treated as employee compensation

and included on employees’ Forms W-2, in reimbursed expenses or are

incurred for firm recreational or social activities (i.e., holiday


Example 4: VCorp. recorded $10,000 in M&E expenses during 2004,

consisting of $5,000 for business lunches with clients and $5,000 for

the annual holiday party. The latter is fully deductible, but the

business lunch deduction is limited to $5,000 ($10,000 x 0.50),

requiring $2,500 to be added back to book income on Schedule M-1 to

arrive at taxable income.

Club Dues

Sec. 274(a)(3) disallows a deduction for amounts paid for

membership in any club organized for business, pleasure, recreation or

other social purpose. All amounts spent on these items should be added

back to arrive at taxable income on Schedule M-1.

Spousal Travel

Sec. 274(m)(3) bars a deduction for travel expenses of a spouse,

dependent or other individual accompanying the taxpayer, unless the

individual is an employee of the taxpayer’s business. All amounts

spent on these items should be added back to arrive at taxable income on

Schedule M-1.

Employee/Shareholder Loans

Sec. 7872(c)(3) states that compensation-related and

corporation-shareholder loans not exceeding $10,000 can carry a

below-market interest rate (unless tax avoidance is a principal

purpose). However, employee loans exceeding $10,000 must accrue interest

at the market rate. Interest-free loans are very common between S

corporations and their shareholders. If the loan balance exceeds

$10,000, a market interest rate must be accrued on the loan’s

average balance.

Example 5: At the beginning of 2005, S corporation D has a $9,000

interest-free note due from shareholder A. During 2005, A borrows an

additional $5,000, bringing the total loan balance to $14,000 at

yearend. Because the balance exceeds the $10,000 de minimis exception, a

market rate of interest must be accrued on the note’s average

balance. The accrued interest computation is as follows, assuming the

applicable Federal rate at the end of 2005 is 6%:

Beginning balance $9,000

Ending balance $14,000

Total $23,000

x 50%

Average $11,500

x 6%

Accrued interest $690

Thus, D must add $690 interest income to its book income on

Schedule M-1 to arrive at taxable income. If the situation had been

reversed and A had loaned the money to D, A would be required to report

$690 interest income on his individual return; D would deduct $690

interest expense from book income in determining its taxable income on

Schedule M-1.


Sec. 162(f) disallows a deduction for any fine or similar penalty

paid to a government for the violation of any law. All amounts spent on

these items should be added back to arrive at taxable income on Schedule

M-1. Similar treatment is required for bribes and other illegal payments

made to the extent deducted in arriving at book income for the year.

Prepaid Expenses

Regs. Sec. 1.461-4(d)(6)(ii) allows a taxpayer to deduct prepayment for services or property if the taxpayer can reasonably expect to

receive the services or property within 3 1/2 months after the payment


Example 6: On Dec. 31, 2004, Z Corp. prepaid its lawn maintenance

company for three months of service and booked the related asset. If Z

expects its lawn maintenance to be performed on its usual monthly

schedule, this amount may be deducted as an expense, even though the

service has not been provided as of the date accrued.

Life Insurance Premiums

Sec. 264(a)(1) allows a deduction for the premiums paid on

group-term life insurance covering employees, if the employer is not

directly or indirectly a beneficiary under the policy or contract.

Example 7: Y Corp. paid $25,000 in life insurance premiums for tax

year 2004, $20,000 of which were for policies under which Y is not the

beneficiary. However, $5,000 of premiums were paid for life insurance

policies covering Y’s officers, for which Y is the beneficiary.

Thus, $5,000 must be added back to book income on Schedule M-1.


Although these are just a few of the many Schedule M-1 adjustments,

they should illustrate the underlying concept. After identifying the

taxpayer’s method of accounting, the all-events test should be

applied to the year’s transactions and adjustments should be made

to transform book income into taxable income.

Some taxpayers engaging in abusive transactions have benefited from

the different rules for book and tax accounting, by claiming tax

benefits that have no corresponding financial cost. To combat this, the

IRS created Schedule M-3, Net Income (Loss) Reconciliation for

Corporations With Total Assets of $10 Million or More, which requires

certain C corporations to disclose detailed information about book-tax

differences as part of their returns for 2004 and later years. All

domestic corporations (including consolidated entities) with total

consolidated assets reported on Schedule L, Balance Sheets per Books, at

the end of the year of at least $10 million are required to complete

Schedule M-3 in lieu of Schedule M-1. These corporations will be treated

as satisfying the disclosure requirements under the return disclosure

regulations by completing Schedule M-3.

In addition, taxpayers not required to file the new schedule may

meet their disclosure obligations by using the standardized reporting

format contained in Schedule M-3 or by following the return disclosure

regulations. (For more information, see McGowan and Killion,

“Schedule M-3: Closing the Corporate Book-Tax Gap” TTA, July

2005, p. 408.)




From Wikipedia, the free encyclopedia

For other uses, see Loan (disambiguation).

In finance, a loan is the lending of money from one individual, organization or entity to another individual, organization or entity. A loan is a debt provided by an entity (organization or individual) to another entity at an interest rate, and evidenced by a promissory note which specifies, among other things, the principal amount of money borrowed, the interest rate the lender is charging, and date of repayment. A loan entails the reallocation of the subject asset(s) for a period of time, between the lender and the borrower.

In a loan, the borrower initially receives or borrows an amount of money, called the principal, from the lender, and is obligated to pay back or repay an equal amount of money to the lender at a later time.

The loan is generally provided at a cost, referred to as interest on the debt, which provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants. Although this article focuses on monetary loans, in practice any material object might be lent.

Acting as a provider of loans is one of the principal tasks for financial institutions such as banks and credit card companies. For other institutions, issuing of debt contracts such as bonds is a typical source of funding.


1 Types

1.1 Secured

1.2 Unsecured

1.3 Demand

1.4 Subsidized

1.5 Concessional

2 Target markets

2.1 Personal

2.2 Commercial

3 Loan payment

4 Abuses in lending

5 United States taxes

5.1 Income from discharge of indebtedness

6 See also

7 References



See also: Loan guarantee

A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral.

A mortgage loan is a very common type of loan, used by many individuals to purchase things. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security – a lien on the title to the house – until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.

In some instances, a loan taken out to purchase a new or used car may be secured by the car, in much the same way as a mortgage is secured by housing. The duration of the loan period is considerably shorter – often corresponding to the useful life of the car. There are two types of auto loans, direct and indirect. A direct auto loan is where a bank gives the loan directly to a consumer. An indirect auto loan is where a car dealership acts as an intermediary between the bank or financial institution and the consumer.


Unsecured loans are monetary loans that are not secured against the borrower’s assets. These may be available from financial institutions under many different guises or marketing packages:

credit card debt

personal loans

bank overdrafts

credit facilities or lines of credit

corporate bonds (may be secured or unsecured)

peer-to-peer lending

The interest rates applicable to these different forms may vary depending on the lender and the borrower. These may or may not be regulated by law. In the United Kingdom, when applied to individuals, these may come under the Consumer Credit Act 1974.

Interest rates on unsecured loans are nearly always higher than for secured loans, because an unsecured lender’s options for recourse against the borrower in the event of default are severely limited. An unsecured lender must sue the borrower, obtain a money judgment for breach of contract, and then pursue execution of the judgment against the borrower’s unencumbered assets (that is, the ones not already pledged to secured lenders). In insolvency proceedings, secured lenders traditionally have priority over unsecured lenders when a court divides up the borrower’s assets. Thus, a higher interest rate reflects the additional risk that in the event of insolvency, the debt may be uncollectible.


Demand loans are short term loans[1] that are typically in that they do not have fixed dates for repayment and carry a floating interest rate which varies according to the prime lending rate. They can be “called” for repayment by the lending institution at any time. Demand loans may be unsecured or secured.


A subsidized loan is a loan on which the interest is reduced by an explicit or hidden subsidy. In the context of college loans in the United States, it refers to a loan on which no interest is accrued while a student remains enrolled in education.[2]


A concessional loan, sometimes called a “soft loan”, is granted on terms substantially more generous than market loans either through below-market interest rates, by grace periods or a combination of both.[3] Such loans may be made by foreign governments to developing countries or may be offered to employees of lending institutions as an employee benefit.

Target markets


See also: Credit (finance) § Consumer credit

Loans can also be subcategorized according to whether the debtor is an individual person (consumer) or a business. Common personal loans include mortgage loans, car loans, home equity lines of credit, credit cards, installment loans and payday loans. The credit score of the borrower is a major component in and underwriting and interest rates (APR) of these loans. The monthly payments of personal loans can be decreased by selecting longer payment terms, but overall interest paid increases as well. For car loans in the U.S., the average term was about 60 months in 2009.


Main article: Business loan

Loans to businesses are similar to the above, but also include commercial mortgages and corporate bonds. Underwriting is not based upon credit score but rather credit rating.

Loan payment

The most typical loan payment type is the fully amortizing payment in which each monthly rate has the same value over time.[4]

The fixed monthly payment P for a loan of L for n months and a monthly interest rate c is:

P=L?c(1+c)n(1+c)n-1displaystyle P=Lcdot frac c,(1+c)^n(1+c)^n-1P=Lcdot frac  c,(1+c)^n(1+c)^n-1

For more information see “Monthly loan or mortgage payments” under compound interest.

Abuses in lending

Predatory lending is one form of abuse in the granting of loans. It usually involves granting a loan in order to put the borrower in a position that one can gain advantage over him or her. Where the moneylender is not authorized, they could be considered a loan shark.

Usury is a different form of abuse, where the lender charges excessive interest. In different time periods and cultures the acceptable interest rate has varied, from no interest at all to unlimited interest rates. Credit card companies in some countries have been accused by consumer organizations of lending at usurious interest rates and making money out of frivolous “extra charges”.[5]

Abuses can also take place in the form of the customer abusing the lender by not repaying the loan or with an intent to defraud the lender.

United States taxes

Most of the basic rules governing how loans are handled for tax purposes in the United States are codified by both Congress (the Internal Revenue Code) and the Treasury Department (Treasury Regulations – another set of rules that interpret the Internal Revenue Code).[6]:111

1. A loan is not gross income to the borrower.[6]:111 Since the borrower has the obligation to repay the loan, the borrower has no accession to wealth.[6]:111[7]

2. The lender may not deduct (from own gross income) the amount of the loan.[6]:111 The rationale here is that one asset (the cash) has been converted into a different asset (a promise of repayment).[6]:111 Deductions are not typically available when an outlay serves to create a new or different asset.[6]:111

3. The amount paid to satisfy the loan obligation is not deductible (from own gross income) by the borrower.[6]:111

4. Repayment of the loan is not gross income to the lender.[6]:111 In effect, the promise of repayment is converted back to cash, with no accession to wealth by the lender.[6]:111

5. Interest paid to the lender is included in the lender’s gross income.[6]:111[8] Interest paid represents compensation for the use of the lender’s money or property and thus represents profit or an accession to wealth to the lender.[6]:111 Interest income can be attributed to lenders even if the lender doesn’t charge a minimum amount of interest.[6]:112

6. Interest paid to the lender may be deductible by the borrower.[6]:111 In general, interest paid in connection with the borrower’s business activity is deductible, while interest paid on personal loans are not deductible.[6]:111The major exception here is interest paid on a home mortgage.[6]:111

Income from discharge of indebtedness

Although a loan does not start out as income to the borrower, it becomes income to the borrower if the borrower is discharged of indebtedness.[6]:111[9] Thus, if a debt is discharged, then the borrower essentially has received income equal to the amount of the indebtedness. The Internal Revenue Code lists “Income from Discharge of Indebtedness” in Section 61(a)(12) as a source of gross income.

Example: X owes Y $50,000. If Y discharges the indebtedness, then X no longer owes Y $50,000. For purposes of calculating income, this is treated the same way as if Y gave X $50,000.

For a more detailed description of the “discharge of indebtedness”, look at Section 108 (Cancellation of Debt (COD) Income) of the Internal Revenue Code.[10][11]

See also

0% finance

Annual percentage rate (a.k.a. Effective annual rate)

Bank, Fractional-reserve banking, Building society

Debt, Consumer debt, Debt consolidation, Government debt

Default (finance)

Finance, Personal finance, Settlement (finance)

Interest-only loan, Negative amortization, PIK loan

Legal financing

Leveraged loan

Loan guarantee

Loan sale

Pay it forward

Payday loan

Refund Anticipation Loan

Student loan

Syndicated loan

Title loan

US specific:


Federal student loan consolidation

Federal Perkins Loan

George D. Sax and the Exchange National Bank of Chicago – Innovation of instant loans

Stafford loan

Student loan default


^ Signoriello, Vincent J. (1991), Commercial Loan Practices and Operations, ISBN 978-1-55520-134-0

^ Subsidized Loan – Definition and Overview at Retrieved 2011-12-21.

^ Concessional Loans, Glossary of Statistical Terms,, Retrieved on 5/5/2013

^ Guttentag, Jack (October 6, 2007). “The Math Behind Your Home Loan”. The Washington Post. Retrieved May 11, 2010.

^ Credit card holders pay Rs 6,000 cr ‘extra’ May 3, 2007

^ a b c d e f g h i j k l m n o p Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 2nd Ed. (2007).

^ See Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) (giving the three-prong standard for what is “income” for tax purposes: (1) accession to wealth, (2) clearly realized, (3) over which the taxpayer has complete dominion).

^ 26 U.S.C. 61(a)(4)(2007).

^ 26 U.S.C. 61(a)(12)(2007).

^ 26 U.S.C. 108(2007).

^ EUGENE A. LUDWIG AND PAUL A. VOLCKER, 16 November 2012 Banks Need Long-Term Rainy Day Funds












Business loan

Consumer lending

Loan shark

Payday loan

Predatory lending





Management plan



Debt-snowball method

Debtor-in-possession (DIP) financing

Loan guarantee

Collection · Evasion

Bad debt


Collection agency


Debt bondage

Debtors’ prison



Phantom debt

Strategic default

Tax refund interception








Deposit account

Fixed income

Money market



Consumer leverage ratio

Debt levels and flows

External / Internal / Odious debt




Interest rate

Retrieved from “”

Arguing the case for a business bad debt deduction.

When a shareholder loans money to a corporation, there is a clear expectation that the loan will be repaid. If the loan becomes worthless, deductibility of the loss for tax purposes is based on two criteria: whether (1) a bona fide debt existed, since advances that are not bona fide loans are generally characterized as capital contributions, and (2) the loan is classified as a business or nonbusiness debt. Business bad debts that are completely or partially worthless are deductible as ordinary losses, while nonbusiness bad debts are short-term capital losses only when entirely worthless.(1)

Under Sec. 166(d)(2), a business bad debt occurs either from a debt created or acquired in connection with the taxpayer’s trade or business, or from the worthlessness of a debt incurred in the taxpayer’s trade or business. The distinction between a business and nonbusiness bad debt is a question of fact and must be determined based on the facts and circumstances. The courts, however, have established minimum criteria that must be met before a business bad debt deduction will be allowed. A general understanding of these criteria can be helpful in establishing the conditions under which the courts may allow a business bad debt deduction. This article will discuss these minimum criteria and provide practical suggestions for shareholders who are contemplating making (or have already made) loans to a corporation, to enhance the likelihood of ordinary loss treatment should the loan become worthless. This article will also discuss the tax consequences when a shareholder guarantees corporate loans.

Debt Versus Capital Contribution

Before considering whether a loan is a business or nonbusiness debt, the shareholder must first establish that the loan is not a contribution to capital. Often, a shareholder of a closely held corporation will advance funds to it without formally documenting that the advance is a loan that is expected to be repaid in the future.(2) This can be a costly mistake if the corporation becomes insolvent and the debt becomes worthless, since only bona fide loans qualify as bad debt losses under Sec. 166.(3)

A bona fide debt “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”(4) In assessing whether an advance to a corporation is a loan or a capital contribution, the courts have concluded that the primary factor is the intent of the parties to the transaction.(5) However, this requires a subjective determination of an individual’s state of mind at the time the advance was made. In determining the shareholder’s intent in advancing funds to a corporation, the courts have identified numerous factors to be considered, including the following:

1. Whether and how the transaction was accounted for on the corporation’s books.

2. Whether the taxpayer and the corporation executed a written agreement.

3. Whether the corporation paid or accrued interest on the loan and whether the taxpayer reported interest income from it.

4. Whether repayment was contingent or based on the corporation’s earnings.

5. Whether the debt was subordinated to other general creditors and if so, to what extent.

6. The level of capitalization of the corporation.(6)

Provided the corporation is not deemed “thinly capitalized,” a properly documented loan agreement, regular interest payments and proper accounting on the corporation’s books should generally preclude a reclassification of a loan as a capital contribution.(7)

Guarantors’ Losses

When a taxpayer makes payments in satisfaction of an agreement under which the taxpayer acted as a guarantor of a debt obligation, a debtor-creditor relationship arises. A payment in discharge of a taxpayer’s obligation under such an agreement is treated as a bad debt when all of the following conditions exist:

1. The agreement was entered into in the course of the taxpayer’s trade or business or a transaction for profit;

2. There was an enforceable legal duty on the taxpayer to make the payment; and

3. The agreement was entered into before the obligation became worthless.(8)

Under the doctrine of subrogation, the taxpayer’s debt does not exist until the corporation defaults on the payment and the taxpayer is forced to satisfy his guarantor obligation.(9) Consequently, a deduction for a bad debt is not allowed until the taxpayer’s rights against the debtor become worthless. However, if the debt is worthless when acquired (as in the case of a guarantor that acquired subrogation rights as the result of a default on the debt by an insolvent corporation], the regulations allow the taxpayer a bad debt deduction by testing the validity of the debt at the time the guarantee obligation was entered into, rather than at the time the guarantor satisfies the obligation.(10)

Business Versus Nonbusiness Bad Debt

Once it has been established that an advance (or a payment made on a guarantee of an obligation) is a bona fide debt, the taxpayer must determine the type of debt it is. Sec. 166(d)(2) defines a nonbusiness debt as a debt other than one created or acquired in connection with the taxpayer’s trade or business, or one in which the loss from worthlessness was incurred in the taxpayer’s trade or business. Accordingly, two conditions must exist before a worthless debt is classified as a business bad debt: (1) the taxpayer must be engaged in a trade or business; and (2) at the time the debt was acquired, created or became worthless, it must have been related to the taxpayer’s trade or business.(11)

Although a shareholder is generally not considered to be engaged in the same trade or business as that of the corporation, shareholders have been successful in claiming ordinary losses for worthless loans to a corporation by establishing that they made the loan either in their capacity as an employee or in the trade or business of acquiring corporations. (Both of these arguments are discussed later.

In determining whether the loss from the debt was incurred in the taxpayer’s trade or business, a debt that is “proximately related” to the taxpayer’s trade or business either when the debt was acquired or created, or at the time of worthlessness, is a business bad debt.(12) Although the extent to which the acquisition or worthlessness of a debt is related to the taxpayer’s trade or business is a question of fact that must be determined based on the facts and circumstances, the courts have developed certain criteria that must be met before a deduction for a business bad debt will be allowed.

In Generes,(13) the Supreme Court concluded that the proper test in determining whether a bad debt was proximately related to the taxpayer’s trade or business is “dominant,” rather than “significant,” motivation. Generes earned $12,000 working part-time as president of a construction company in which he owned 44% of the stock. He took a $162,000 business bad debt deduction for payments made to a bonding company that had loaned money to the corporation under an indemnity agreement with the taxpayer.(14) The Court found no evidence to support the taxpayer’s claim that his “sole” motivation in signing the indemnity agreement was to protect his salary and position as an employee.

The Supreme Court instructed the courts to “compare the risk against the potential reward and give proper emphasis to the objective rather than to the subjective” in determining whether a taxpayer’s dominant motivation is attributable to his trade or business.(15) In reaching its decision, the Court weighed heavily the following objective factors:

* Generes derived three-quarters of his total income from other sources.

* His investment in the corporation was significantly larger than his annual salary.

* The remainder of the corporation’s stock was owned by close relatives.

Before a taxpayer can claim that the dominant motivation behind a debt was attributable to his trade or business, the taxpayer first must be engaged in a trade or business. For purposes of Sec. 166, a shareholder generally is not in the same trade or business as the corporation, even when the shareholder owns a controlling interest.(16) However, to the extent that the shareholder is also an employee of the corporation, the shareholder is in the trade or business of being an employee.

Trade or Business of Being an Employee

To satisfy the dominant motivation standard, an employee of a corporation must demonstrate that the loan was made to the corporation (or third-party loans were guaranteed) to protect his salary and position as an employee. Clearly, when the employee does not own an equity interest in the company, there is no issue concerning the taxpayer’s motives for making the loan. However, in an attempt to motivate employees, it is becoming more common for companies to ask or require high-level employees to make equity investments in the business, or to make or guarantee business loans. In these situations, the loans or guarantees should clearly qualify as business loans, because the dominant motive for making them is to protect the employee’s position in the company.

In general, the key factors to be considered by shareholder-employees who make loans to (or guarantee loans of) a corporation include:

* The level of investment in the company.

* The level of salary received from the company.

* The amount of the loan or guarantee in relation to the first two factors.

* The amount of income derived from other sources.

* The relative size of the taxpayer’s investment in the corporation to his annual salary.

* The taxpayer’s ownership percentage in the corporation and his relationship to those owning the remainder of the corporation’s stock.

* The taxpayer’s ability to find comparable employment elsewhere.(17) The Litwin(18) case illustrates how these various factors have been used in determining a taxpayer’s dominant motivation behind making and guaranteeing loans. Litwin sold his wholly owned corporation, but continued to work for the company and act as chairman of the board. After a subsequent change in ownership, his responsibilities and salary were reduced. At the time, the Litwin was 73 and unable to find comparable employment elsewhere. In an attempt to provide himself with employment and a comparable salary, Litwin started another business.

Although the new business had good long-term prospects, it developed cash flow problems. To keep the business going, Litwin made several loans to the corporation and guaranteed loans from banks that totaled over $1.5 million. Because of the company’s cash problems, Litwin deferred part or all of his salary for several years.

Later on, he sold a controlling interest in the company, retaining only a small percentage of its stock. The bank, however, required Litwin to renew his guarantee on the loans to the corporation. Eventually, the corporation failed and he was forced to honor his guarantees to the bank. Litwin deducted as business bad debts the payments that were made to the bank in satisfaction of these guarantees. The district court ruled in Litwin’s favor and allowed a business bad debt deduction.

In determining Litwin’s motives for making and guaranteeing the loans, the court considered the taxpayer’s age and the fact that the loan guarantee ultimately satisfied was actually a renewal of the guarantees after he sold a controlling interest in the business. As a result, the return Litwin could have expected from his investment in the company was significantly lower than the salary he received. Notwithstanding the fact that the guarantee might have been necessary to complete the sale transaction, Litwin apparently demonstrated to the court that it was entered into to protect his continued employment. Had Litwin not sold his controlling interest in the company, a different conclusion regarding his motives might have been reached. Finally, the considerable amount of time Litwin spent working with and for the company after selling most of his stock was an important factor.

Generally, if a taxpayer’s investment (at the time of the loan or guarantee) in the company is substantially less than his company salary, a strong argument can be made that the loan or guarantee was made to protect the salary income. Also, when a taxpayer is actively engaged in the management of a business, without expectation of significant future capital gain, the employment-related argument is strengthened. Even when the potential gains from the taxpayer’s equity interest could be larger than the amounts received as salary, the courts have not ruled out the possibility that the taxpayer could have had a dominant employment-related motive for making loans to the corporation.(19)

Another significant aspect in support of a business bad debt classification is that many shareholder-employees rely on their salary, not on their investment (which may or may not be substantial relative to salary), to pay day-to-day living expenses, since investments generally do not provide regular cash income.

Example: T is a vice president and 10% owner of a personal service corporation (PSC). The PSC was initially capitalized at $100,000, making T’s initial investment $10,000. The shareholders of the PSC personally guarantee loans to the corporation; T’s share of such guarantees is (100,000.(20) If T’s annual salary as a vice president is $65,000, it would be difficult for the IRS to argue successfully that T guaranteed loans in excess of his salary to protect a $10,000 investment.(21) Instead, a strong argument could be made that T’s dominant motivation for guaranteeing the loans must have been to maintain his salary and position in the company, and that he was not primarily concerned with the value of the investment.

This argument becomes even stronger when the taxpayer’s right to sell stock is limited by the corporation (e.g., a provision granting the corporation the right of first refusal on any sale of stock by the taxpayer, using a formula that is not directly related to market value to determine the purchase price). Additionally, in the case of a PSC, when a shareholder will receive only the return of his initial investment on departure from the company, there is little doubt that loans or guarantees of loans made by the taxpayer were made in his capacity as an employee, not to protect his investment. However, if the taxpayer could easily earn a similar salary elsewhere without guaranteeing the corporation’s debt, this argument is weakened.

When a taxpayer loans money to a business he created in the belief that he could work only for a corporation in which he held a substantial ownership interest, the courts have held that the taxpayer must provide convincing evidence that the primary motivation for starting up the business was his inability to work for others.(22) However, other valid business reasons exist for starting up a business, and if the only way the taxpayer can receive a salary is by establishing his own business, provided that the appropriate criteria have been met, a business bad debt deduction should be allowed. This argument should apply even when the potential for capital gain is apparent.

Trade or Business of Acquiring Corporations

A taxpayer may also claim a business bad debt deduction as a shareholder-employee by demonstrating that he is in the trade or business of seeking out business ventures to acquire, promote, finance, derive a salary from and sell at a profit. This approach is somewhat more limited, as it is more appropriate for entrepreneurs who are major shareholders of several corporations, each of which the taxpayer is actively involved in managing or promoting.

When the taxpayer is engaged in a trade or business that involves several businesses, a debt connected to one of the taxpayer’s endeavors is per se connected to his overall trade or business.(23) However, for a taxpayer to argue successfully that he is in the trade or business of acquiring corporations, he must be able to distinguish his activities from those of an investor.

A debt created or acquired in connection with an activity which, when taken alone, does not constitute a trade or business, but rather is viewed as a segment of a larger overall trade or business, qualifies as a business bad debt with respect to the overall trade or business, provided the relevant criteria are met.(24) Again, it is important for the taxpayer to establish that the kinds of gains derived from the endeavor are not the same as those marking an investor’s return (which are generally characterized as gain from dividends or enhancement in the value of the investment). When the taxpayer’s primary return from the business is ordinary income and the potential for substantial capital gain is relatively small, it is more likely that the court will find a business motive behind the shareholder’s loan to the corporation.

Even if the taxpayer’s return is directly linked to the services he provides to the corporation, the Supreme Court has held that when the return is that of an investor, the taxpayer has not satisfied the burden of demonstrating that he is engaged in a trade or business. Additionally, if full-time service to one corporation does not constitute a trade or business, it is difficult to establish how the same service to several corporations constitutes a trade or business.(25) However, if the type of return is that of a noninvestor, it is possible that the activity will be considered a trade or business. In making this determination, both the extent to which the taxpayer performs these services and the amount of ordinary income generated from such services are important factors.

In some instances, activities not traditionally considered to be a trade or business may be classified as such when they are performed extensively and result in the primary source of income to the taxpayer. For example, if the taxpayer derives the majority of his income from and spends the majority of his time in the pursuit of profit from trading securities, he will be deemed to be engaged in the trade or business of being a securities trader.(26) Another example is a taxpayer who, as a livelihood, devotes the majority of his time and effort to speculating on the stock exchange. In this case, losses incurred as a result of these activities may be treated as having been incurred in the course of a trade or business.(27)

In general, the key factors to be considered when determining whether the taxpayer is in the trade or business of seeking out business ventures to acquire, promote, finance, derive a salary from and sell at a profit are:

* The taxpayer’s income and time spent in pursuit of profit from such activity in relation to other activities.

* The number of business ventures the taxpayer participated in during the relevant periods.

* The types of services provided by the taxpayer.

The argument of being in the business of seeking out business opportunities that could be profitably financed or promoted is enhanced if the taxpayer participates in numerous business ventures throughout the relevant periods of the case. For example, support for the claim may exist if the taxpayer could list five specific loans he made that allowed the debtors to acquire businesses, as well as at least five other ventures in which he invested in hopes of deriving a profit from the future sale of their investments. This argument would be strengthened if the taxpayer could show that he typically invested in or financed these companies, served as financial adviser to the debtors or managers of the businesses, and then sold the interests, usually to the persons who were managing the companies.(28)

Similarly, a taxpayer who bought and sold over 30 businesses generally would be considered to be engaged in the trade or business of developing and promoting businesses, primarily because buying and selling businesses for profit may constitute a trade or business, even though the promoter does not receive a fee, commission or other “noninvestor” compensation.29 In such instances, it is necessary for the taxpayer to demonstrate that the dominant motivation behind buying and selling businesses was to earn ordinary income, not to realize potentially large amounts of capital gain. To support this argument, the taxpayer might have to substantiate that he took an active role in developing and promoting the businesses.

Timing of the Deduction

In general, a bad debt deduction is allowed in the tax year in which the debt becomes worthless. For a business bad debt, a loss is also deductible when the loan becomes partially worthless.(30) For loan guarantees, provided the bad debt criteria have been met, the deduction is allowed in the tax year in which payment is made. When either a cash-or accrual-basis taxpayer satisfies his obligation under such an agreement with a promissory note, the deduction is allowed when the note is paid, as a bad debt arises only after the taxpayer has made an outlay of cash or of property having a cash value.(31)

Therefore, in situations in which the taxpayer is forced to satisfy a guarantee obligation but does not have the cash available, he may be tempted to sign a note promising to pay the debt in the future. However, the taxpayer is better off borrowing the money from a third party (e.g., a financial institution) to satisfy the obligation. Under both scenarios, the taxpayer must repay the corporation’s initial debt; however, in the latter case, the taxpayer is able to claim a bad debt deduction immediately.


When a taxpayer is a shareholder-employee in a closely held corporation, the salary derived from his position as an employee is often greater than the amount of his investment in the company. In such a case, the IRS may presume that the taxpayer loaned money to or guaranteed loans of the corporation (usually in amounts far exceeding both investment and salary) to protect his investment in the company. It is more likely, however, that the taxpayer loaned money to (or guaranteed loans of) the corporation either as a condition of employment or to help get the business off the ground and provide himself with a salary. In these cases, it is more reasonable to assume that the taxpayer loaned money to the corporation to preserve a periodic income to cover ordinary living expenses, and that the investment was of secondary concern relative to this desire.

The argument can be made for a taxpayer to claim a business bad debt deduction for advances made or guarantees of loans to a corporation of which he is both a shareholder and employee, provided that the facts clearly indicate that the taxpayer’s dominant motivation for the loans was to protect his salary and position as an employee. Several cases also support the notion that extensive business activity in the area of corporate acquisitions can constitute a trade or business, and that bad debts related to such a business are deductible as business bad debts. However, before taking a position with respect to the deductibility of a bad debt, taxpayers finding themselves in either of these two positions should consider whether they are able to produce enough evidence to support a business bad debt deduction, as the final determination of any bad debt case rests on an analysis of the facts and circumstances.

Accordingly, when a taxpayer loans money to or guarantees loans of a corporation, a written agreement should be prepared that clearly reflects the taxpayer’s reasons for entering into the agreement. To successfully claim a business bad debt deduction in the event that the debt becomes worthless, the circumstances at the time of the agreement should support the taxpayer’s contention regarding his motivation. The following is a list of suggestions that may be used to support the taxpayer’s intentions.

* A written agreement should be executed, stating the terms of the loan.

* The loan should be interest-bearing (using a market rate of interest), made to the corporation, and not specifically subordinated to the corporation’s general creditors.

* When guaranteeing a loan on behalf of a corporation, the shareholder should document on the bank note the purpose of the guarantee.

* In the case of a shareholder-employee who is required to make loans to the corporation, the employment agreement should be clarified to reflect that the employee is required to loan money to or guarantee the debts of the corporation in his capacity as a (senior) employee of the company. (1) Regs. Sec. 1. 166-5(a)12). (2) In the case of a shareholder with See. 1244 stock, it may be more beneficial to the taxpayer to have the debt reclassified as equity. (3) Regs. See. 1.166-1(c). (4) Id. (5) This assumes that the corporation is not thinly capitalized. See Los Angeles Shipbuilding & Drydock Corp., 289 F2d 222 (9th Cir. 1961)(7 AFTR2D 984, 61-1 USTC [paragraph]9329); and Jeannette H. Jennings, 272 F2d 842 (7th Cir. 1959)(4 AFTR2D 6000, 60-1 USTC [paragraph]9136). (6) Otis Newell Elliott, 268 F Supp 521 (DC Ore. 1967)(19 AFTR2D 1323; 67-1 USTC [paragraph]H9368); Leonard Lundgren, 376 F2d 623 (9th Cir. 1967)(19 AFTR2D 1407,67-1 USTC [paragraph]9389); John W. Hough, 882 F2d 1271 (7th Cir. 1989)(64 AFTR2D 89-5569, 89-2 USTC [paragraph]9508), aff’g TC Memo 1986-229; Ray A. Van Clief, 135 F2d 254 (D.C. Cir. 1943)(30 AFTR 1417, 43-1 USTC 99384). (7) Even when the debt is clearly identified as such and treated as a debt on the corporate books, it may be reclassified as equity if the debt-to-equity ratio suggests that the corporation is thinly capitalized. Plantation Patterns, Inc., 462 F2d 712 15th Cir. 1972)(29 AFTR2D 72-1408, 72-2 USTC [paragraph]9494), cert. denied. (8) Regs. Sec. 1.166-9(d). However, a bad debt deduction would not be allowed if, at the time the obligation was entered into, the shareholder-guarantor’s payment is construed as a contribution to capital. (9) Max Putnam, 352 US 82 (1956)(50 AFTR 502, 57-1 USTC [paragraph]9200), aff’g 224 F2d 947 (8th Cir. 19551(47 AFTR 1562, 55-2 USTC [paragraph]19604), aff’g TC Memo 1954-141. (10) Regs. Sec. 1.166-9(c). (11) Regs. Sec. 1.166-5(b). (12) Id. (13) Edna Generes, 405 US 93 11972)(29 AFTR2D 72-609, 72-1 USTC [paragraph]19259). For purposes of loan guarantees, the dominant motivation test is applied at the time the guarantee obligation was entered into, not at the time of payment (Regs. Sec. 1. 166-9(d)(1)). (14) This was treated as a bad debt because the company defaulted on several projects and subsequently went into receivership, leaving the taxpayer with no possibility for recovery from the company. This should not be confused with a situation in which the taxpayer makes payments under such a guarantee with an expectation of repayment from the company. (15) Generes, note 13, at 72-1 USTC 83,960. (16) “|A corporation and its stockholders are generally to be treated as separate entities.'” A.f. Whipple, 373 US 193 (1963)(11 AFTR2D 1454,63-1 USTC [paragraph]19466), citing Burnet v. R.P. Clark, 287 US 410 (1932)(11 AFTR 1103, 3 USTC [paragraph]10101, at 63-1 USTC 88,268. (17) Harry Litwin, 983 F2d 997 (10th Cir. 1993)(71 AFTR2D 93-647, 93-1 USTC [paragraph]50,041), aff’g DC Kans., 1991 (67 AFTR2D 91-1098, 91-1 USTC [paragraph]150,229); Generes, note 13; James C. Garner, 987 F2d 267 (5th Cir. 1993)(71 AFTR2D 93-1307, 93-1 USTC [paragraph]50,167), aff’g TC Memo 1991-569. (18) Litwin, id. (19) Litwin, note 17. (20) In this situation, it is possible that some or all of the loan guarantees may be reclassified as capital contributions if the Service argues that the corporation is thinly capitalized. See note 7. (21) In a PSC, amounts are generally paid out to owners as salary, as opposed to dividends or capital gains. (22) Donald C. Niblock, Jr., 417 F2d 1185 (7th Cir. 1969)(24 AFTR2D 69-5792, 69-2 USTC [paragraph]9704), aff’g TC Memo 1968-260. (23) Vincent C. Giblin, 227 F2d 692 (5th Cir. 1955)(48 AFTR 478, 56-1 USTC [paragraph]9103). (24) Lundgren, note 6. (25) Whipple, note 16. (26) Samuel B. Levin, 597 F2d 760 (Ct. Cl. 1979)(43 AFTR2D 79-1057, 79-1 USTC [paragraph]9331), adopting Trial Judge’s Report (U.S. Ct. Cl. Trial Div. 1979)(43 AFTR2D 79-612, 79-9 USTC [paragraph]9176). (27) John A. Snyder, 295 US 134 11935)(15 AFTR 1081, 35-1 USTC [paragraph]9344). (28) Elliott, note 6. (29) Frank L. Farrar, TC Memo 1988-385. (30) See. 166(a)(2). (31) Stanley Halle, TC Memo 1983-760; Black Gold Energy Corp., 99 TC 482 (1992).

Shareholder advances and business bad debt deductions.

When individuals who are shareholders in corporations (especially closely held corporations) must provide their companies with additional funds, they should identify the potential consequences; the manner in which such advances are made will affect their tax treatment (especially if the corporation is unable to repay the funds).


The first thing to determine is whether a shareholder’s advance to a corporation was a valid debt that he or she expected to be repaid in the future or a contribution to the corporation’s capital.

In making this determination, the primary factor is the parties’ intent. While this can be a very subjective determination, these objective factors are considered:

* How the transaction was accounted for on the business’s books.

* The existence of a written agreement between the shareholder and the corporation.

* Whether the company paid interest, and whether the shareholder reported interest income.

* Whether repayment was contingent on company earnings.

* Whether the debt was subordinate to (or included with) that of other general creditors.

* The corporation’s level of capitalization.

Business bad debts. Individual taxpayers may deduct two different types of bad debts: business bad debts, which are deductible as ordinary losses if completely or partially worthless, and nonbusiness bad debts, which are short-term capital losses taken only when entirely worthless. A business bad debt arises from a debt created or acquired in connection with a taxpayer’s trade or business, or from the worthlessness of a debt incurred in the taxpayer’s trade or business. All other bad debts are nonbusiness.

Business versus nonbusiness bad debt. Once a debt is determined to be bona fide, it must be determined whether the debt is business or nonbusiness. A debt is classified as a business bad debt if the taxpayer is engaged in a trade or business and, at the time the debt was acquired, created or became worthless, the debt was proximately related to that trade or business (there must be a dominant business reason–and not merely a significant one–for the loan).


Since devoting one’s time and energies to a corporation’s affairs is not in and of itself a trade or business, a shareholder generally is not considered as being in the same trade or business as his or her corporation. However, if shareholders can establish that they made loans to their corporations in the course of a trade or business (for example, as an employee, in the business of money lending, in the business of acquiring and promoting corporations or in some other commercial relationship), this requirement may be met.

Employee. To satisfy the dominant motivation standard, a corporate employee must show that a loan to the company was made to protect his or her salary and position as an employee. If the employee has no equity interest in the corporation, the motive for making such a loan should be clear. If the company is asking its employees to make equity investments or to guarantee business loans, such loans or guarantees still clearly can qualify if protection of the employee’s position remains the dominant motive for the advances. Factors considered when determining the dominant motive for a loan or guarantee include

* The employee’s level of investment in the company.

* The level of salary received.

* The amount of the loan or guarantee in relation to the employee’s investment or salary.

* The employee’s income from other sources.

* The size of the employee’s investment relative to his or her salary.

* The percentage of the employee’s ownership interest in the corporation and any relationship to those owning the remainder of the company’s stock.

* The employee’s ability to find employment elsewhere.

For a detailed discussion of these issues, see “Arguing the Case for a Business Bad Debt Deduction,” by David Zinneman, Linda Johnson and David Webster, in the August 1994 issue of The Tax Adviser.

Taxpayers on hook for $139 million after loan to failed green automaker is sold

Taxpayers are on the hook for a multi-million-dollar tab after a U.S. Department of Energy gamble on a green automaker went into the red.

The Obama administration announced Friday it will lose $139 million on a loan to struggling electric car maker Fisker Automotive Inc. after selling part of the loan to a private investor that immediately took the company into bankruptcy.

The transaction brings to an end another effort by the Obama administration to use public funds to stimulate green initiatives. Awarded a $529 million loan guarantee by the administration in 2009 to produce the Karma, a $103,000 luxury hybrid car, Fisker failed to meet DOE benchmarks, causing it to lose its loan guarantee two years later. The company drew down on $192 million before its federal funding was pulled, and the Obama administration seized $21 million from the company in April to help repay taxpayers. 

Hybrid Technology LLC, the California car marker’s new owner, said it plans to keep Fisker operating after it emerges from bankruptcy. 

The government lost $528 million in the Solyndra collapse, triggering sharp Republican criticism of the loan program and President Barack Obama’s investments in green energy.

“Fisker’s collapse closes yet another sad chapter in DOE’s troubled portfolio. The jobs that were promised never materialized and, once again, taxpayers are on the hook for the administration’s reckless gamble,” House Energy and Commerce Committee Chairman Fred Upton, R-Pa., and House Oversight and Investigations Subcommittee Chairman Tim Murphy, R-Pa., said in a joint statement. 

Fisker backers were heavily involved in lobbying the Obama administration and Congress on green energy programs, The Daily Caller reported. The venture capital firm Kleiner, Perkins, Caufield and Byers — where Al Gore is a partner — was a seed investor in Fisker and spent $400,000 in 2009 and 2010 on lobbying. The firm helped push for the stimulus bill that handed out $90 billion in green energy programs. 

The department’s actions, along with the sale, mean the Energy Department has protected nearly three-quarters of its original commitment to Fisker, Energy spokesman Bill Gibbons said Friday.

“While this result is not what anyone hoped, the ($139 million loss) represents less than 2 percent of our advanced vehicle loans, and less than one-half of 1 percent of our overall loan program portfolio” of more than $30 billion, Gibbons said.

Corporate Lending | Comerica

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