8662. When can a taxpayer deduct losses sustained as a result of a bad debt? What is the difference between a business bad debt and a nonbusiness bad debt?Alexis Longrcline202014-07-07T22:47:00Z2014-07-07T22:47:00Z24662657Hewlett-Packard2263117148662. When can a taxpayer deduct losses sustained as a result of a bad debt? What is the difference between a business bad debt and a nonbusiness bad debt?A bad debt is a specific obligation which can be deemed with reasonable certainty to have become totally or partially worthless. If this is the case, the creditor-taxpayer may be entitled to a deduction corresponding to the amount of the worthless debt..Treas. Reg. §1.166-1. There are two kinds of bad debt deductions: (1) business bad debts and (2) nonbusiness bad debts. A business bad debt, as the name suggests, is a debt that is incurred in the conduct of the taxpayer’s trade or business. A nonbusiness bad debt is defined, by exclusion, in IRC Section 166(d)(2) as a bad debt other than a debt (a) created in the conduct of the taxpayer’s business.IRC Sec. 166(d)(2)(A); Treas. Reg. §1.166-5(b)(1). or (b) the loss from the worthlessness of which was incurred in the conduct of the taxpayer’s trade or business..IRC Sec. 166(d)(2)(B); Treas. Reg. §1.166-5(b)(2). The second exclusionary rule allows a taxpayer who was not the original creditor to claim a worthless debt that he acquired in the conduct of his business. The classification as either a business or nonbusiness bad debt is important because only a business bad debt can be treated as a deduction from ordinary income, while nonbusiness bad debts receive a capital loss treatment..IRC Sec. 166(a) and (d). Further, a taxpayer can claim a deduction for wholly or partially worthless business bad debts, while nonbusiness bad debts must be completely worthless for the deduction to be allowed (see Q 8665)..IRC Sec. 166(d)(1).Whether a debt is incurred in relation to a taxpayer’s trade or business, so as to be classified as a business bad debt, is a question of fact..Commissioner v Smith, 203 F.2d 310 (1953), Nicholson v Commissioner, 218 F.2d 240 (1954). In making the determination, it is important to note that a taxpayer is not restricted to one type of business and that there is no requirement that the loss be incurred in conducting the business in which the taxpayer spends the majority of taxpayer’s time..Gliptis v United States, 120 F. Supp. 3 (1954). A deduction for a loss sustained as the result of a bad debt will only be permitted in cases where there is a valid debt and a true debtor-creditor relationship (see Q 8663). Whether a valid debt or a true debtor-creditor relationship exists is also a question of fact..Leuthold v. Commissioner, 54 TCM 1308 (1987); Lane v. United States, 83-2 USTC 9524 (1983).A bad debt deduction will not be allowed in a situation where the debt is secured by collateral and the creditor has foreclosed on the collateral due to nonpayment..Rose v Commissioner, TC Memo 1987-19. Bad debts of corporations, except for S corporations, are always classified as business bad debts..IRS Publication 535. An S corporation is required to separately state its nonbusiness bad debt, which is taxed under the rules applicable to short-term capital losses (see Q 8557)..See Rev. Rul. 93-36; 1993-1 CB 187, Treas. Reg. §301.7701-2. A discharge of one’s obligation as a guarantor is considered a nonbusiness bad debt..Putnam v Commissioner, 352 US 82 (1956).If the debt fails to qualify as a business bad debt, it can, in many cases, be treated as a nonbusiness bad debt..See Krasnow v United States, 508 F. Supp. 1099 (1981). If the taxpayer fails to establish that a debt qualifies as a business bad debt under IRC section 166, he must be satisfied with treatment as a non-business bad debt under that same section and may not look to IRC section 165 (see Q8667) for an alternative means of treating loss on the debt as an ordinary loss deduction..Alsobrook v. United States, 431 F. Supp. 1122 (E.D. Ark.), aff’d 566 F. 2d 628 (6th Circuit 1977).