Venture Capitalist Can Deduct Bad Loan to Associate

When a loan that you’ve made goes sour and cannot be repaid, you may be able to claim a tax deduction for this bad debt. If the loan was a personal one, the deduction for a nonbusiness bad debt is claimed as a short-term capital loss. If the loan was business related, it is a fully deductible business loss. Unfortunately, it’s not always easy to distinguish between a personal and business loan. Take the following case:

A venture capitalist made a loan of $5 million to an associate who experienced financial difficulties following the burst of the dot-com bubble in 2000. The borrower made business referrals to the lender. The borrower continued to have financial problems, and by 2003 could not make payments on the loan. The lender accepted securities of $364,782 in full satisfaction of the debt; he deducted $3.6 million as a business bad debt on his tax return for this year of forgiveness.

The IRS argued that the loan was a personal loan so the loss should be treated as a short-term capital loss. Alternatively, the IRS said the loan was related to the lender’s employee status, making the loss a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income floor.

The Tax Court rejected both of the IRS’s arguments and sided with the lender. The court concluded that he was in the business of being a venture capitalist because he managed venture capital funds and that the loan was related to his business activity. The dominant motive for making the loan was to secure referrals from the borrower related to his venture capital activity. Thus, the loss was a business bad debt, which is fully deductible.

Source: Todd A. Dagres et ux. v. Commissioner; 136 T.C. No. 12