Introduction: Why a Nonbusiness Bad Debt Hits Americans in Britain Twice
A nonbusiness bad debt is the label the IRS gives to almost every loan a private individual makes that is never repaid. For an American living in Britain, that label matters far more than it does at home. You lend sterling to a UK company, the company fails, and two tax authorities then apply two different rulebooks to one loss. Furthermore, those rulebooks disagree on when the loss arises, how large it is and what it can offset.
Wealthy Americans in London make these loans constantly. A banker backs a former colleague's fintech. A founder props up her own trading company through a director's loan account. An investor signs a personal guarantee so that the bank will extend a facility. Consequently, when the business collapses, the money is gone and a nonbusiness bad debt claim is often the only recovery left.
What a Nonbusiness Bad Debt Means for a US Lender in London
Under section 166 of the Internal Revenue Code, a nonbusiness bad debt is any debt that was not created in your own trade or business and whose loss does not arise in that trade or business. Importantly, the business of the borrower is irrelevant. The regulations state that the use to which the debtor puts the borrowed funds is of no consequence. Therefore, a loan to a thriving trading company is still a nonbusiness debt in your hands if you made it as an investor.
Britain asks the opposite question. HMRC ignores your status and looks only at the borrower. Specifically, relief depends on whether the borrower used the money wholly for a trade. As a result, the same loan can qualify in one country and fail in the other.
Who Needs to Read This
This guide is written for US citizens and green card holders resident in the UK who have lent money to a private company, hold a credit balance on a director's loan account, or have guaranteed company borrowing. Additionally, it covers dual nationals who have never reported such a loan on a US return, or never claimed a nonbusiness bad debt they were entitled to. At TaxYork we prepare both the US and UK returns for clients in exactly this position, and the same mistakes recur every year.
How the IRS Treats a Failed Loan
The US rules for a nonbusiness bad debt are narrow, mechanical and unforgiving on timing. However, they are also predictable once you know the three tests.
Total Worthlessness Is the Only Trigger
The IRS allows nothing for a partial loss. Its Topic 453 on bad debt deductions confirms that a nonbusiness bad debt must be totally worthless to be deductible. A company that is struggling, or has repaid sixty per cent and stalled, gives you no deduction at all. Moreover, the regulations on nonbusiness debts state that no deduction is allowed for a debt that is recoverable in part during the year.
You do not need a court judgment to claim a nonbusiness bad debt. IRS Publication 550 says a debt becomes worthless when there is no longer any chance that the amount owed will be paid. Furthermore, it treats the debtor's bankruptcy as good evidence of worthlessness for an unsecured debt. For a UK borrower, the equivalent evidence is an administrator's or liquidator's report confirming that unsecured creditors will receive nothing.
A Short-Term Capital Loss, Whatever the Holding Period
A nonbusiness bad debt on a loan held for ten years still produces a short-term loss. Section 166(d) treats the loss as arising from the sale of a capital asset held for not more than one year. Consequently, the loss first offsets your capital gains. After that, section 1211 lets only $3,000 a year reduce ordinary income, or $1,500 if you are married and file separately. The balance carries forward indefinitely.
For a high earner with no gains, that limit is brutal. A $500,000 loss with no gains to absorb it would take well over a century to use at $3,000 a year. Therefore, the practical value of a nonbusiness bad debt depends almost entirely on having capital gains in the same year or in later years.
Business or Nonbusiness: The Dominant Motive Test
Many director-shareholders assume their loan is a business debt because they work for the company. The Supreme Court closed that door in United States v. Generes. The court held that a shareholder-employee's loss is a business bad debt only if protecting the salary was the dominant motive, not merely a significant one. In practice, where the investment dwarfs the salary, the loss is a nonbusiness bad debt.
The Employee Trap That Makes Nonbusiness the Better Answer
Here is a point most US guides still miss. Winning the business argument as an employee no longer helps. A bad debt arising from the trade of being an employee is not deductible in reaching adjusted gross income. Instead, it is a miscellaneous itemised deduction. Section 67 suspended those deductions from 2018, and the 2025 legislation made the suspension permanent. As a result, an employee who proves a business bad debt now generally receives no deduction at all. Accordingly, for a salaried director, the nonbusiness bad debt route is the only one that produces relief.
Proving the Loan Was Real: Debt, Equity and Phantom Interest
Before the IRS allows a nonbusiness bad debt, it asks whether a debt existed at all. For owner-managed UK companies, that question decides most disputes.
A Genuine Debt Needs Evidence
Publication 550 requires a true debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum. Therefore, you need a written loan agreement, a stated interest rate, a repayment date and evidence that you pursued repayment. A bare credit entry on a director's loan account, with no terms and no interest, is weak evidence. Similarly, money advanced to a friend's company on the understanding that it may never come back is treated as a gift.
When the IRS Calls Your Loan Share Capital
If the company was thinly capitalised and no outside lender would have advanced the money, the IRS can treat your advance as equity. In that case the nonbusiness bad debt rules fall away. Instead, the loss follows the worthless stock rules, which usually give a long-term capital loss on the last day of the year. Notably, the ordinary loss available to investors in small American companies is closed to UK companies, as our guide to Section 1244 stock and UK companies explains.
Interest-Free Loans Create Phantom Income
British directors routinely lend to their own companies interest-free, because the UK does not tax interest that is never charged. The US takes a different view. Section 7872 applies to any below-market loan between a corporation and a shareholder, in either direction, once total loans between them exceed $10,000. Consequently, the IRS can treat you as receiving interest at the applicable federal rate each year. Because the UK charges no tax on that deemed interest, no foreign tax credit shelters it. Furthermore, on a demand loan the deemed interest is treated as a contribution to the company's capital, not as an addition to the loan, so it does not increase a later bad debt deduction.
The Disregarded Company Problem
Some Americans elect to treat a wholly owned UK limited company as a disregarded entity. In that case the IRS ignores the company entirely, so a loan from you to it does not exist for US purposes. Therefore, no nonbusiness bad debt can arise. Instead, the company's losses already flowed onto your own return as they were incurred. HMRC, however, still sees a separate company and a real loan.
How HMRC Treats the Same Loan
The UK starts from a harsh default and then offers one statutory rescue.
The Default: No Gain and No Loss on a Simple Debt
Under section 251 of the Taxation of Chargeable Gains Act 1992, no chargeable gain accrues to the original creditor on the disposal of an ordinary debt. Because allowable losses mirror chargeable gains, an ordinary loan that goes bad produces no UK capital loss either. Consequently, without a specific relief, the failed loan is simply ignored.
Loans to Traders Relief Under Section 253
The rescue is section 253, known as relief for loans to traders. A qualifying loan needs three features. First, the borrower must use the money wholly for a trade, profession or vocation, and that trade must not be money lending. Second, the debt must not be a debt on a security. Third, you and the borrower must not be spouses or civil partners at any time from the making of the loan. HMRC accepts in its Capital Gains Manual that credit balances on directors' loan accounts are capable of qualifying.
Therefore, a loan to a property investment company, a family investment company or a dormant holding vehicle fails the trade test. In that situation Britain gives nothing, while the US may still allow a nonbusiness bad debt deduction.
The 2019 Change Most UK Guides Still Get Wrong
Many widely read UK articles still say the borrower must be resident in the United Kingdom. That is out of date. The statute now applies the residence condition only if the loan was made before 24 January 2019. As a result, an American in London who lent to a trading company in Delaware, Dublin or Dubai after that date can claim UK relief on the same footing as a loan to a British company. Importantly, older loans to non-UK borrowers remain outside the relief.
What Irrecoverable Means to HMRC
HMRC applies a forward-looking test. Its guidance on irrecoverability asks whether there was no reasonable prospect of recovery at the date claimed. Officers consider funds potentially available, not just the current balance sheet. Moreover, if the borrower is still trading, even at a loss, the initial presumption is that the loan remains recoverable. Additionally, the loan must not have become irrecoverable because of its own terms or because of any act or omission by you as lender.
Claim Timing and the Two-Year Look-Back
The UK loss arises when you make the claim, not when the company fails. However, you may specify an earlier time if the loan was already irrecoverable then. That earlier time must fall no more than two years before the start of the tax year in which you claim. For a claim made in 2026/27, the earliest date is therefore 6 April 2024. This flexibility is valuable, because it lets you place the loss in the year that holds your gains. The US nonbusiness bad debt rules offer no such choice.
What Destroys the UK Relief
Three actions commonly forfeit the claim. Assigning the debt removes it. Converting the loan into shares before claiming removes it too, because HMRC's manual on the other conditions for relief says no relief is due where the loan has been satisfied by an issue of shares, even worthless ones. Finally, structuring the advance as a loan note can turn it into a debt on a security, which falls outside section 253. Where the instrument is a share rather than a loan, different rules apply, and our guide to the negligible value claim covers them.
Personal Guarantees: When the Bank Calls on You
Guarantees are the second route to a nonbusiness bad debt, and the timing rules differ again.
The US Rule for Guarantors
The regulations on guarantor losses treat a payment under a guarantee as a worthless debt. If you gave the guarantee in a transaction for profit, but not in your own trade or business, the payment is treated as a nonbusiness bad debt. Three conditions apply. You must have had an enforceable legal duty to pay. You must have given the guarantee before the underlying debt became worthless. Additionally, you must show that you received reasonable consideration, although protecting your own investment in the company generally satisfies that test.
Timing depends on your rights against the company. Where the guarantee gives you a right of subrogation, the loss is deferred until that right is itself totally worthless. In an insolvent liquidation with nothing for unsecured creditors, that is normally the year of payment. Notably, a guarantee that amounted to a capital contribution when you signed it produces no bad debt at all.
The UK Rule for Guarantors
Section 253(4) gives a guarantor an allowable loss when the payment is made, provided the underlying loan would have been a qualifying loan. Unlike the lender's claim, the guarantor's relief also covers irrecoverable interest. However, a strict deadline applies. You must claim within four years after the end of the tax year in which you paid. Any contribution due from a co-guarantor reduces the loss.
Why the Payment Date Matters So Much
Both countries fix the guarantor's loss by reference to the payment date. Britain uses a tax year ending on 5 April. America uses the calendar year. Therefore, a payment made in January, February or March falls into one UK year but a later US year than a payment made the previous December. As the case study below shows, that gap can strand a six-figure nonbusiness bad debt.
Where the Two Systems Collide
Treating the two claims as one loss is the central error. A nonbusiness bad debt and a section 253 loss are separate reliefs with separate clocks.
The Tax Year Mismatch
The IRS insists that you deduct a nonbusiness bad debt only in the year it becomes worthless. Claim it a year late and the deduction belongs to a closed-looking year. Meanwhile, HMRC lets you choose the claim date within a two-year window. Consequently, the sensible sequence is to fix the US year first, using the insolvency evidence, and then position the UK claim around your UK gains.
Sterling Loans and Dollar Basis
The amount of a nonbusiness bad debt is your basis in dollars. For a sterling loan, that basis is the dollar value of each advance on the day you made it. The UK loss, by contrast, is the sterling principal outstanding. As a result, the two figures diverge whenever the exchange rate has moved. Additionally, a sterling loan is a foreign currency instrument for US purposes, so a repayment at a different rate can create a currency gain. Our guide to foreign currency gains on sterling balances explains the principle.
Loss Sourcing and the Foreign Tax Credit
A nonbusiness bad debt can damage your foreign tax credit if it reduces foreign-source income. The loss allocation regulations expressly cover bad debt deductions under section 166. For a US citizen with a foreign tax home, the loss reduces foreign-source income only if a gain on the same property would have been taxable abroad at a rate of at least ten per cent. Because section 251 exempts the original creditor's gain on a simple debt, our reading is that the loss falls against US-source income instead. Therefore, a properly structured loan should not erode the credit you need for UK tax on other gains. A debt on a security, however, could produce the opposite result.
Waivers, Releases and the Company's Tax Bill
Formally waiving the loan carries risks on both sides. In the US, a voluntary release by a shareholder is treated as a contribution to capital under section 108(e)(6), not as worthlessness. Consequently, releasing a debt that still has some value can forfeit the nonbusiness bad debt deduction. In the UK, a release can create a taxable credit in the company unless an exemption in section 322 of the Corporation Tax Act 2009 applies, such as insolvent liquidation or administration. HMRC does accept that waiving a loan that was already irrecoverable does not block a section 253 claim. Nevertheless, you should take the US position before signing any release.
Recoveries After the Claim
Occasionally a liquidator pays a late dividend. In the UK, section 253(5) treats the recovery as a chargeable gain equal to the corresponding part of the earlier loss. In the US, the recovery is income to the extent the earlier nonbusiness bad debt reduced your tax. Therefore, both returns need adjusting, often in different years.
Case Study: A London Managing Director and a Failed Fintech Loan
The following illustration uses invented facts and assumed exchange rates. Nevertheless, it reflects a pattern we see regularly.
The Facts
Dana is a US citizen and a managing director at a bank in London. In March 2023 she lent £400,000 to a UK trading company founded by a former colleague, in which she held fifteen per cent of the shares. The loan was documented, carried interest at six per cent and was used wholly in the trade. At an assumed rate of $1.25, her dollar basis was $500,000. She also guaranteed a £150,000 bank facility.
The company entered administration in February 2026. In July 2026 the administrators reported that unsecured creditors would receive nothing. In September 2026 Dana sold quoted shares, realising a gain of £600,000 for UK purposes and $780,000 for US purposes. The bank then called on her guarantee, and she planned to pay in January 2027.
The UK Result
Both events fall in the 2026/27 tax year. Dana claims £400,000 under section 253(3) and £150,000 under section 253(4), giving losses of £550,000. Her gain falls from £600,000 to £50,000. After the £3,000 annual exempt amount, £47,000 is taxed at the 24 per cent higher rate of Capital Gains Tax, costing £11,280. Without the claims, the bill would have been £143,280. Consequently, the relief saves her £132,000.
The US Result as Planned
The US splits the same loss across two years. The loan became totally worthless in 2026, so Dana has a $500,000 nonbusiness bad debt that year. Her 2026 net gain is therefore $280,000. At the 20 per cent maximum long-term capital gains rate plus the 3.8 per cent net investment income tax, the US charge before credits is $66,640. The guarantee payment in January 2027, worth $195,000 at an assumed rate of $1.30, belongs to 2027. With no gains that year, only $3,000 offsets her income and $192,000 carries forward.
The Fix
Dana instead agrees with the bank to settle the guarantee on 18 December 2026. The UK position is unchanged, because December still falls in 2026/27. However, the second nonbusiness bad debt moves into 2026. Her net gain drops to $85,000 and the US charge before credits falls to $20,230. As a result, a three-week change in the payment date saves $46,410 of US tax in the year it matters. The UK tax of £11,280 on the remaining gain may still be available as a credit, subject to the sourcing rules and a treaty claim.
Reporting, Deadlines and Disclosure
Good evidence and correct forms decide whether a nonbusiness bad debt survives a challenge.
The US Return
You report a nonbusiness bad debt on Form 8949, Part I, entering the debtor's name and the words "bad debt statement attached". The basis goes in column (e) and zero in column (d). The attached statement must describe the debt and its due date, name the debtor and any business or family relationship, set out your collection efforts and explain why you decided the debt was worthless. Additionally, each bad debt needs its own line.
The Seven-Year Safety Net
Because the year of worthlessness is so hard to pin down, Congress gave a longer refund window. Under section 6511(d), a refund claim based on a bad debt may be made within seven years of the original filing date, instead of the usual three. Therefore, Americans who missed a nonbusiness bad debt on an earlier return can often still amend. Where earlier US returns were never filed at all, the loss should be built into the catch-up filings, and our US tax return preparation service handles that work.
Form 8938 and the Loan Itself
A loan to a UK company is a reportable asset long before it fails. The Form 8938 instructions list a note, bond, debenture or other form of indebtedness issued by a foreign person as a specified foreign financial asset. Consequently, a director's loan balance counts towards your reporting threshold even though it sits in no bank account. A missing Form 8938 for the years the loan was outstanding invites exactly the questions you want to avoid when you claim the loss. Our FBAR and FATCA reporting service reviews these disclosures.
The UK Return
You make the section 253 claim in the capital gains pages of your Self Assessment return, and HMRC's helpsheet HS296 on debts and Capital Gains Tax explains the entries. Keep the loan agreement, bank statements showing the advance, the insolvency practitioner's reports and evidence of how the company used the money. Furthermore, where UK tax remains payable on other gains, the US-UK treaty decides how that tax is credited, as HMRC's collection of USA tax treaty documents sets out. Our treaty and foreign tax credit service covers that step.
How TaxYork Can Help
TaxYork prepares US and UK returns together, so one team sees both sides of a failed loan. We establish the US year of worthlessness from the insolvency record, draft the nonbusiness bad debt statement and compute the dollar basis of every sterling advance. In addition, we prepare the section 253 claim, choose the claim date around your UK gains and check the guarantee deadlines. Where a loan was never disclosed on Form 8938, or US returns were missed altogether, we bring the filings up to date before the loss is claimed. Our work follows the technical guidance published by the ICAEW Tax Faculty, the Chartered Institute of Taxation and the AICPA, and we build every loss claim on contemporaneous evidence.
Conclusion
A failed loan to a UK company produces two reliefs, not one. The IRS gives a nonbusiness bad debt deduction as a short-term capital loss, only on total worthlessness and only in the correct calendar year. HMRC gives a capital loss under section 253, only for trading borrowers and only on a claim. Moreover, the two losses differ in amount, currency and timing. Therefore, the planning lies in aligning them with your gains: fixing the US year from the evidence, placing the UK claim within its two-year window and paying any guarantee before 31 December where gains exist. Above all, document the loan properly while the company is still solvent.
Contact Us
If you have lent money to a UK company that is failing, or a bank has called on your guarantee, speak to us before you sign a waiver or make a payment. You can book a consultation with our US-UK team, email hello@taxyork.com or call 020 3488 8606. We will review the loan documents, the insolvency position and both sets of returns.
Disclaimer
This article provides general information only and does not constitute tax, legal or financial advice. Tax rules change, and their application depends on your individual circumstances. The case study is illustrative and uses assumed figures and exchange rates. You should obtain professional guidance from a qualified US-UK tax specialist before acting on any matter discussed here. TaxYork accepts no liability for actions taken in reliance on this content.