If someone owes you money that you are not going to be able to collect, you have a bad debt. There are two kinds of bad debts-business and nonbusiness. This article discusses only business bad debts.
Generally, a business bad debt is one that comes from operating your trade or business. You can deduct business bad debts on your business income tax return. A business bad debt is a loss from the worthlessness of a debt that was either created or acquired in your trade or business, or closely related to your trade or business when it became partly or totally worthless. A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. Bad debts of a corporation are always business bad debts.
Types of Business Bad Debts
The following are situations that may result in a business bad debt:
Loans to clients and suppliers:
If you loan money to a client, supplier, employee, or distributor for a business reason and subsequently, after making attempts to collect, the loan receivable becomes worthless, you have a business bad debt.
Debts of Political Parties:
If a political party (or other organization that accepts contributions or spends money to influence elections) owes you money and the debt becomes worthless, you can claim a bad debt deduction only if you use an accrual method of accounting and meet all the following tests:
1. The debt arose from the sale of goods or services in the ordinary course of your trade or business.
2. More than 30% of your receivables accrued in the year of the sale were from sales to political parties.
3. You made substantial and continuing efforts to collect on the debt.
Loan or capital contribution:
You cannot claim a bad debt deduction for a loan you made to a corporation if, based on the facts and circumstances, the loan is actually a contribution to capital.
Debts of an insolvent partner:
If your business partnership breaks up and one of your former partners becomes insolvent, you may have to pay more than your pro rata share. If you pay any part of the insolvent partner's share of the debts, you can claim a bad debt deduction for the amount you paid that is attributable to the insolvent partner's share.
Business loan guarantee:
If you guarantee a debt that subsequently becomes worthless, the debt can qualify as a business bad debt if all the following requirements are met:
1. You made the guarantee in the course of your trade or
business.
2. You have a legal duty to pay the debt.
3· You made the guarantee before the debt became worthless. You meet this requirement if you reasonably expected you would not have to pay the debt without full reimbursement from the issuer.
4· You receive reasonable consideration for making the guarantee. You meet this requirement if you made the guarantee in accord with normal business practice or for a good faith business purpose.
Deductible in the year paid:
If you make a payment on a loan you guaranteed, you can deduct it in the year paid, unless you have rights against the borrower.
Rights against a borrower:
When you make payment on a loan you guaranteed, you may have the right to take the place of the lender. The debt is then owed to you. If you have this right, or some other right to demand payment from the borrower, you cannot claim a bad debt deduction until these rights become partly or totally worthless.
Joint debtor:
If two or more debtors jointly owe you money, your inability to collect from one does not enable you to deduct a proportionate amount as a bad debt.
Sale of mortgaged property:
If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt.
When a Debt Becomes Worthless:
You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no longer any chance the amount owed will be paid. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You must only show that you have taken reasonable steps to collect the debt. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.
How To Claim a Business Bad Debt:
There are two methods to claim a business bad debt. First, the specific charge-off method. Second, the nonaccrual-experience method. Generally, you must use the specific charge-off method. However, you may use the nonaccrual-experience method if you meet the requirements discussed later under nonaccrual-experience method.
Specific Charge-Off Method:
If you use the specific charge-off method, you can deduct specific business bad debts that become either partly or totally worthless during the tax year.
Partly Worthless Debts:
You can deduct specific bad debts that become partly uncollectible during the tax year. Your tax deduction is limited to the amount you charge off on your books during the year. You do not have to charge off and deduct your partly worthless debts annually. You can delay the charge off until a later year. However, you cannot deduct any part of a debt after the year it becomes totally worthless.
Significantly Modified Debt:
An exception to the charge-off rule exists for debt which has been significantly modified and on which the holder recognized gain. For more information, see Regulations section 1.166-(3)(a)(3).
Deduction Disallowed:
Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. If, under audit, the IRS does not allow your deduction and the debt becomes partly worthless in a later tax year, you can deduct the amount you charge off in that year plus the disallowed amount charged-off in the earlier year. The charge off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year.
Totally Worthless Debts:
If a debt becomes totally worthless in the current tax year, you can deduct the entire amount, less any amount deducted in an earlier tax year when the debt was only partly worthless. You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. However, you may want to do so. If you do not and the IRS later rules the debt is only partly worthless, you will not be allowed a deduction for the debt in that tax year. A deduction of a partly worthless bad debt is limited to the amount actually charged off.
Filing a Claim for Refund:
If you did not deduct a bad debt on your original return for the year it became worthless, you can file a claim for a credit or refund. If the bad debt was totally worthless, you must file the claim by the later of the following dates. 7 years from the date your original return was due (not including extensions). 2 years from the date you paid the tax. If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates: (1) 3 years from the date you filed your original return or (2) 2 years from the date you paid the tax.
You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. Such an impairment requires proof of existence. See Code section 6511(h).
Recovery of a Bad Debt:
If you claim a deduction for a bad debt on your income tax return and later recover (collect) all or part of it, you may have to include all or part of the recovery in gross income. The amount you include is limited to the amount you actually deducted. However, you can exclude the amount deducted that did not reduce your tax. Report the recovery as "Other income" on the appropriate business form or schedule.
