Business owners are often faced with providing financing to their businesses especially during difficult economic times. The intent generally, is for the company to pay the owner's monies back "at some point in the future" before the business terminates. However, sometimes the loan to the business cannot be paid back and becomes a bad debt. Bad debts can be either business bad debts which are deducitble against other income or, nonbusiness bad debts which can be deductible only in certain specific circumstances.
A business bad debt occurs when the debt is related to the lender's trade or business. Case law has established that a corporation's business is not always the business of the owner simply because of the corporation-shareholder relationship. Being an employee, however, is a trade or business so if the business owner is compensated as an employee, there may be an opportunity for the bad debt to be fully deductible.
The owner/employee must show that the main purpose for making a loan to their business is to protect their EMPLOYMENT. Unlike a loan from a shareholder which is generally classified as investment related, an employee loan could be considered to be made to protect the employee's trade or business, i.e. their paycheck.
The following four items indicate that protecting a paycheck was the primary purpose for a loan by a shareholder/employee.
• The employee's net pay was much larger that his investment in the company
• The employee had minimum other sources of income indicating dependence on the salary from the company
• The time spent in an employee role was substantial
• The value of the shareholder's investment in the company was insignificant when the loan was made
When shareholder loans are a regular form of fincancing for a business, it is beneficial to review the position of the debt in terms of collectibility, and purpose on an annual basis.
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