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Bad Debt Deduction
Generally, taxpayers may deduct the value of bona fide debts
owed to them that become worthless during the year. Sec. 166(a).
Bona fide debts generally arise from valid debtor-creditor
relationships reflecting enforceable and unconditional
obligations to repay fixed sums of money. Sec. 1.166-1(c),
Income Tax Regs. For purposes of section 166, contributions to
capital do not constitute bona fide debts. Kean v. Commissioner,
91 T.C. 575, 594 (1988).
The question of whether transfers of funds to closely held
corporations constitute debt or equity must be decided on the
basis of all the relevant facts and circumstances. Dixie Dairies
Corp. v. Commissioner, 74 T.C. 476, 493 (1980). Taxpayers
generally bear the burden of proving that the transfers
constituted loans and not equity investments. Rule 142(a).
Courts look to the following nonexclusive factors to
evaluate the nature of transfers of funds to closely held
corporations: (1) The names given to the documents evidencing
the purported loans; (2) the presence or absence of fixed
maturity dates with regard to the purported loans; (3) the likely
source of any repayments; (4) whether the taxpayers could or
would enforce repayment of the transfers; (5) whether the
taxpayers participated in the management of the corporations as a
result of the transfers; (6) whether the taxpayers subordinated
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Last modified: May 25, 2011