George Saadian was part of what is apparently the extremely tight-knit “Persian Jewish” community of California. In 1998, he loaned $200,000 to a distant relative, a property developer with a good reputation within the community as an honest and successful businessman. The note called for interest to be paid at 8% a year, with the principal due on January 2, 2000.
Apparently, the borrower’s sterling reputation was a tad undeserved, as he failed to repay the loan. Saadian reached out to the borrower several times over the years to solicit repayment, but didn’t pursue any type of legal action until 2004, when Saadian’s attorney threatened a suit if the loan wasn’t repaid immediately.
Ultimately, however, Saadian refrained from suing the borrower, for fear of how it would be perceived within the community if one member pursued the debt of another via legal action. Complicating matters further, the borrower died in December 2004. Saadian attempted to recover the loan from the borrower’s sons, but his attempts were fruitless.
On his 2006 tax return, Saadian took a $200,000 nonbusiness bad debt deduction, which partially offset a large capital gain. The IRS denied the deduction, claiming that Saadian failed to establish that the debt was worthless.
As a reminder, nonbusiness bad debt — as opposed to business bad debt, which is granted ordinary loss treatment but is typically afforded only to C corporations and taxpayers in the trade or business of making loans — is deductible as a short-term capital loss. However, in order to prove either type of bad debt, it is incumbent upon the taxpayer to establish the debt’s worthlessness.
Unfortunately, there is no bright-line test for worthlessness; rather, it’s one of the many “facts and circumstances” analysis that often leave taxpayers vulnerable to IRS interpretation.
In general, the year of worthlessness must be fixed by identifiable events that constitute reasonable grounds for a creditor to abandon any prospect of recovery. Importantly, a debt is not worthless merely where it is difficult or uncomfortable to collect.
Taking what we view to be an unduly harsh view of Saadian’s loan, the Tax Court agreed with the IRS that Saadian’s decision not to enforce the debt through legal channels because of the potential social implications was fatal to his position that the debt was worthless.
We describe the court’s opinion as harsh because typically, the judicial standard for the determination of worthlessness has leaned towards being pragmatic — requiring the lender to use sound business judgment — rather than legal. Previous decisions have permitted many factors, often falling fall short of legal action, to fix a debt’s worthlessness. I woudl expect an appeal is forthcoming.
Of course, even if the debt in Saadian were held to be worthless, the proper timing of the bad debt would likely be an issue, as 2006 was a full six years after the maturity date of the note, and two years after the death of the borrower.
