In the recent case of Dagres v. Commissioner, (March 28, 2011), the taxpayer accomplished something that is relatively hard to do. Todd Dagres convinced the Tax Court that a loan he had made that went bad should give rise to a business bad debt deduction. Normally, when an individual loans money to someone and does not get paid back, he is entitled to a deduction for a “non-business bad debt,” which is treated as a short term capital loss. Capital losses can only be deducted against capital gains, except for $3,000 per year which can be deducted against ordinary income. Taxpayers who do not have capital gain income receive virtually no benefit from a non-business bad debt deduction.
A business bad debt deduction is taken against ordinary income and therefore has greater value to an individual taxpayer. In order for an individual taxpayer to receive a business bad debt deduction, he must establish that the loan was made in or acquired in connection with his trade or business. If you run a grocery store as an individual proprietor and extend credit to your customers, any credit losses would be business bad debts. If you loan money to your cousin and he does not pay you back, your loss would be a non-business bad debt.
Todd Dagres was a venture capitalist who completed transactions through various entities. He loaned $5,000,000 to a business associate who had fallen on hard times. He believed the associate would continue to be a valuable source of leads for possible deals. Upon making the loan, Mr. Dagres had an understanding with the borrower that the borrower would tell Mr. Dagres about any investment opportunities of which he became aware. The hard times continued for the borrower, and Mr. Dagres eventually wrote-off most of the loan. He claimed a business bad debt deduction and the IRS challenged that characterization.
The Tax Court had to determine in what capacity Mr. Dagres made the loan. He worked as an employee of the management company that managed the venture capital funds on behalf of their general partners. If the loan was made in his capacity as an employee, then the deduction, even if related to his business of being an employee, would be a miscellaneous itemized deduction, the utility of which is severely limited. He also was an investor in the funds. If the loan was made in his capacity as an investor, it would be a non-business bad debt. Finally, Mr. Dagres was a member of the LLC’s that were the general partners of the venture capital funds. The court found that the loan was made related to his activities as a member of the general partner LLC, which was responsible for finding deals and raising capital for the funds. The court found that this activity was a trade or business of the LLC’s and therefore a trade or business of Mr. Dagres as a member.
While the success of Mr. Dagres in the Tax Court is very unusual, if you have made a loan that has gone bad, it is worth taking a few moments to think through whether the loan had a connection to some business activity in which you are engaged. This case shows that an individual can have a trade or business that is less obvious than running a grocery store.