When to write off bad debt.

Determining whether a debt has become worthless always is a question of fact which requires consideration of all pertinent evidence--including the debtor's financial condition and the value of any security for the debt. A recent Tax Court decision focused on some key factors in making such a determination.

Maurice E. John Jr. was an eye surgeon and sole owner of John Eye Clinic Inc., a professional corporation. In 1987, the taxpayer hired John Evans to serve as the clinic's business manager. Because of Evans' outstanding performance, the clinic became significantly more successful and profitable.

In 1991, as shrinking Medicare reimbursements reduced the clinic's income, Evans suggested to John they diversify by offering management services to other clinics for a fee. In addition to the U.S. market, Evans saw economic opportunities in Russia as the Soviet bloc began to collapse. John agreed to provide the necessary capital while Evans was to manage and develop the businesses. For this Evans was to receive a 50% ownership interest.

Between 1992 and 1995 John advanced about $2.5 million to the ventures, while Evans made no capital contributions. John determined that Evans owed him $491,054 for his share of the investment. Although John never entered into a promissory note with Evans, he had always expected Evans to "work off" his share of the capital contributions if the ventures ever failed.

In 1995, due to a lack of profitability, John instructed Evans to stop making investments in Russia. Evans, however, continued to do so. John fired him and filed suit to recover Evans' share of capital in January 1996. Although the legal action was settled out of court, John claimed a bad debt deduction in the amount of $491,054 on his 1995 tax return. The IRS challenged the deduction.

Result. For the IRS. According to the Tax Court, the debt did not become wholly worthless in the year in which the taxpayer claimed the deduction. While a taxpayer need not be an "incorrigible optimist" with respect to the value of a debt, he or she may not substantiate the worthlessness of a debt with his or her pessimism. Thus, a taxpayer must provide sufficient evidence to demonstrate a debt is indeed worthless and not merely surmise any collection effort would be futile. Consequently, the Tax Court focused on three main issues: Can a job termination render a debt worthless? Does the loan have future value? Were reasonable steps taken to collect the debt?

There is no case law that shows job termination leads to loan worthlessness. In fact, the converse has been held true. In Southwestern Life Insurance, the Fifth Circuit Court of Appeals denied a bad debt deduction for unpaid loans to employees who simply left the company. There was no relationship between the termination and the worthlessness of the loans. Therefore, in the case at hand, because the repayment of the advances was not conditioned on Evans' continued employment, the Tax Court held the termination was insufficient to render the debt worthless.

On the second question, John argued that because Evans was insolvent and owned no significant assets, the loan must be worthless. But the Tax Court, as well as the Seventh Circuit, has long held that insolvency does not, of itself, demonstrate worthlessness. Furthermore, it is incumbent upon the taxpayer to show that the worthless security lacks "future value." In making this determination, the courts take into consideration several factors, such as the debtor's age, educational status and future earnings potential. Because Evans was in his forties, had an MBA from Vanderbilt University and quickly found new employment after termination from the clinic, the court held the loan had, at the very least, some future value.

Finally, a taxpayer must exhaust all reasonable means of collecting the debt in order to prove its worthlessness. There was no evidence John ever took affirmative steps, other than filing the lawsuit, to enforce collection of the amounts owed him by Evans. Moreover, his lawsuit was filed primarily to compel Evans to cease activities and not to collect a debt. The court further rejected John's rebuttal that he did not want to destroy Evans financially, just to prove the debt was worthless. Based on these considerations, the Tax Court held that reasonable steps were not taken to collect the debt.

* Maurice E. John Jr. v. Commissioner, TC Memo 2004-257, November 9, 2004.

Steven C. Thompson, CPA, PhD. associate professor of accounting, Texas State University, San Marcos, and David W. LaRue, PhD, associate professor of accounting, University of Virginia, Charlottesville.