Article: Make Bad Debts Good for Your Tax Bill

December 2002

Make bad debts good for your tax bill

You can deduct bad debts in the year in which they become worthless or any year thereafter

In business, few things can create more aggravation and threats to cash flow than an uncollectible account or note receivable. But if your company is an accrual-basis taxpayer, bad debt offers one shred of good news: You can generally deduct it on your company’s tax return.

The IRS defines bad debt in various ways, and here’s how to deal with them from a tax perspective.

You can deduct bona fide, totally worthless, non-business bad debts and totally or partially worthless business bad debts in the year in which the debts become worthless.

The IRS’s determination of whether a debtor-creditor relationship exists is based on the facts and circumstances, including the parties’ subjective intent. Any of the following circumstances may lend credence to the legitimacy of a debt:

Evidence of indebtedness exists.
The creditor charged interest.
The debt has a fixed maturity debt and/or fixed repayment schedule.
The debtor provided security or other collateral to ensure repayment.
The debtor made repayments.
The debtor wasn’t insolvent at the time the creditor extended credit.

If a debt arises between family members, between shareholders and their corporations, or between affiliated corporations, the IRS will closely scrutinize even a bona fide transaction to determine whether the transfer was, instead of a loan, actually a gift or a capital contribution. In such cases, it is even more important to show that the loan had a legitimate business purpose, that the transaction was properly documented, and that both parties entered into the transaction with the expectation that the loan was to be repaid.

Business bad debts. Business bad debts typically arise as a result of credit sales to customers. The goods or services for which your customers have yet to pay appear on your books as either accounts receivable or notes receivable.

If you’re unable to collect any part of the accounts or notes receivable, the uncollectible part is a business bad debt. You can take a bad-debt deduction for those receivables only if you included the unpaid balance in your gross income for the year in which you are claiming the deduction, or for a prior year.

It is important to note that you don’t have to wait until a debt is delinquent to determine that it’s worthless. A debt becomes worthless when there’s no longer any chance of repayment.

The IRS treats business bad debts more favorably than nonbusiness bad debts. Business bad debts that become worthless are deducted as ordinary losses, while nonbusiness bad debts that become worthless are deducted as short-term capital losses.

Because you must show that a debt has no value at the end of the year, you need to point to certain factors or events that took place during the year to support your contention. Although a decline in the debtor’s business is the most common cause of bad debt, other events that may signify worthlessness are:

the debtor’s death,
the debtor’s disappearance or departure from the country,
the worthlessness of a judgment against the debtor,
a decline in the value of property that secures the debt, or
a deficiency’s uncollectability on the sale of mortgaged property.

Evidence that a debtor is having financial problems alone doesn’t establish worthlessness.

Nonbusiness bad debts. Nonbusiness bad debts are different from business bad debts, and you need to treat them differently. According to the IRS, nonbusiness bad debts are any debts not created or acquired in connection with a trade or business. A nonbusiness bad debt cannot be a bad debt for income tax purposes unless it becomes totally worthless, and you can deduct it only in the tax year in which the debt became worthless.

If you can’t receive the nonbusiness bad debt’s full benefit in the year it becomes totally worthless because of capital-loss limitations, you can carry forward the remaining amount indefinitely, until you use it in its entirety.

Accounting differences. The ways in which you treat bad debt vary depending on the method of accounting your business uses.

If you’re an accrual-basis taxpayer, you report income as it’s earned, collected or not. Thus, you can take a bad-debt deduction for an uncollectible receivable if you have included the uncollectible amount in your taxable income.

If you’re a cash-basis taxpayer, you can’t take a bad-debt deduction for amounts owed to you that you haven’t received and can’t collect.

Guarantees. If you guarantee a debt that becomes worthless, the debt can qualify as a business bad debt if you: (a) made the guarantee in the course of your trade or business, (b) have a legal duty to pay the debt, or (c) made the guarantee before the debt became worthless.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.