Deducting Business Bad Debt

IN THIS ARTICLE

Defining business bad debt

Distinguishing a loss from a bad debt

Business bad debt tax treatment

Claiming the business bad debt tax deduction

Allowance for doubtful accounts

In any business, there are times when accounts receivables and other debts owed to the business become uncollectible. While too many unpaid obligations can cause financial strain for the company, writing off business bad debt can offer some tax relief and minimize its overall loss. The key is understanding how to properly account for and deduct business bad debt for tax purposes.

Defining business bad debt

Business bad debt is an account or note receivable that will remain unpaid and uncollectible. It usually stems from a customer or debtor failing to pay an amount they owe – because they either dispute the amount due, become insolvent, or go out of business.

Business bad debts arise in connection with a taxpayer’s trade or business. They might include:

• Loans to clients, vendors, or employees
• Credit sales to customers
• Business loan guarantees

All loans made by corporations are automatically treated as business debts. Loans made by an individual or by a business operated as a proprietorship or partnership will qualify as business debts if they are created or acquired in connection with a trade or business, or they become worthless in connection with a trade or business.

The use to which the debtor put the borrowed funds is not relevant.

IRS rules treat business bad debt differently from nonbusiness bad debts. Business bad debts are fully deductible – provided they meet specific criteria set by the Internal Revenue Service (IRS).

When does a debt become worthless?

A debt becomes worthless when the facts and circumstances indicate there is no reasonable expectation that the debt will be repaid. In other words, the subjective opinion of the taxpayer that the debt is uncollectible, or a debtor’s current inability to repay the debt is not sufficient evidence that the debt is worthless.

To demonstrate that a debt is worthless, the taxpayer must exhaust all reasonable means of collecting the debt.

Some events that the courts have recognized as indicating worthlessness include:

• Insolvency
• Bankruptcy
• The inability to locate a debtor who has abandoned their obligation on the debt

However, these or other events alone do not necessarily establish the debt is worthless. The taxpayer must make (and document) all reasonable efforts to collect the debt. However, they are not required to take legal action if the facts and circumstances clearly establish that such action would be futile.

Distinguishing a loss from a bad debt

In some cases, a business might have a situation that could be characterized as either a loss or a bad debt. When both the loss deduction and bad debt provisions potentially apply, the taxpayer does not have a choice regarding the characterization of the transaction. Any transaction within the literal language of both provisions must be treated as a bad debt, even if it is more advantageous to claim a loss deduction.

Business bad debt tax treatment

Section 166 of the Internal Revenue Code (IRC) provides three ways for taxpayers to claim a bad debt write-off:

1. An ordinary deduction for the tax year in which a business bad debt becomes completely worthless
2. An ordinary deduction for the tax year in which a business bad debt becomes partially worthless and
3. A short-term capital loss for the tax year in which a nonbusiness bad debt becomes completely worthless

In other words, partially worthless business bad debts may be deductible, while nonbusiness bad debts are only deductible when they become completely worthless.

To deduct bad debt, a taxpayer must prove five things:

1. The existence of a debtor-creditor relationship

The debtor must be legally obligated to pay the taxpayer-creditor a fixed or determinable sum of money. While not strictly necessary, it’s helpful to have an enforceable contract, loan agreement, or other legal document specifying the amount of the loan and the terms of repayment to establish the existence of a debtor-creditor relationship.

If the taxpayer voluntarily advanced money to someone when they had no legal obligation to do so, it’s not a valid debt, and they cannot claim a deduction if they do not receive repayment.

A valid debt also doesn’t arise from a taxpayer advancing money with the understanding that the obligation to repay is conditional. For example, suppose the taxpayer loaned money to another business with the understanding that the debtor wouldn’t need to repay the loan unless the company becomes successful. In that case, the IRS is likely to treat the advance as a capital contribution – especially if the debtor business is inadequately capitalized and there is a substantial risk of nonpayment.

2. The obligation is one described in IRS Sec. 166

It must be either a partially or wholly worthless business bad debt or a completely worthless nonbusiness bad debt.

3. The debt’s adjusted basis for determining loss if the debt was sold or exchanged

The adjusted basis of a completely worthless debt generally equals one of these:

• The face amount of the debt
• The outstanding debt balance if the taxpayers received principal payments
• For trade notes or accounts payable, the amount previously recognized as taxable income

If the taxpayer received property in partial settlement of the debt, the fair market value of the property received reduces their basis in the debt.

4. If the debt represents an item of income, the taxpayer must show that it has been (or is being) taken into income

This rule generally prevents cash-basis taxpayers from claiming a deduction for business bad debts, as it would result in a double benefit: exclusion from income and a deduction.

5. The debt became wholly worthless in the taxable year or, if it is a business bad debt, it was worthless, at least to the extent of the portion charged off by the taxpayer

Voluntary or gratuitous cancellation of indebtedness by the taxpayer doesn’t establish worthlessness. The taxpayer must prove that the debt became worthless in the year they claim the deduction – not a prior or subsequent year.

Some examples of proof that a debt has become partially or totally worthless include:

• The disappearance or death of the debtor (published obituary, return mail marked “Deceased,” etc.)
• The uncollectibility of a debt after the property securing it has been sold
• A writ of execution returned by a sheriff or similar official noting “No Property Found” or “Not Satisfied”
• An uncollectible court judgment against the debtor

If the taxpayer does not have any of the above examples to prove that the debt is worthless, the next best option is to maintain a detailed record of their collection efforts – letters, invoices, and phone calls – showing they made every reasonable effort to collect on the debt.

Claiming the business bad debt tax deduction

Taxpayers can claim business bad debts as an ordinary and necessary business expense on the applicable tax return:

• Sole proprietors and single-member LLCs: Part V, Other Expenses on Schedule C (Form 1040)
• Partnerships and multimember LLCs: Line 12 of Form 1065
• S Corporations: Line 10 of Form 1120-S
• C Corporations: Line 15 of Form 1120

If, in a subsequent year, the taxpayer receives payment on a debt they previously deducted as worthless, they must include the recovered amount in gross income in the year of the recovery.

It is often difficult to prove that a debt became worthless in a particular year. If the IRS later argues that a debt became worthless in an earlier year than the one in which the taxpayer claimed the deduction, the taxpayer may lose their ability to deduct the loss because the statute of limitations for claiming a federal income tax refund has expired.

To address this situation, IRC Sec. 6511(d) extends the statute of limitations for claiming a refund for bad debts to seven years rather than the usual three years.

In any event, it’s a good idea to claim a bad debt deduction in the earliest year it could possibly be allowed. If the facts and circumstances later indicate a different year is the proper one for claiming the bad debt write-off, you can file an amended return for the original year.

Allowance for doubtful accounts

Companies that regularly sell their goods or services on credit typically use a contra asset account called the allowance for doubtful accounts to reduce the book value of the company’s accounts receivable by the amount management estimates won’t be collectible.

There are two primary ways to estimate the amount of receivables that won’t be converted into cash:

1. Percentage of credit sales. Under this method, if the company and/or industry has an average of 2% of credit sales being uncollectible, the company would record 2% of each period’s credit sales as an increase in the allowance for doubtful accounts.
2. Accounts receivable aging. Under this method, the company lists all unpaid receivables by date range and applies a rate of default to each range. For example, the company might estimate that 1% of all current receivables will be uncollectible, 10% of 31–60-day receivables will be uncollectible, and 25% of all receivables 60 days or older will be uncollectible.

Whichever method is used, once the company estimates its uncollectible receivables, the entry to record bad debt and its corresponding allowance is:

Knowing when to write off a business bad debt can be complicated, but Bloomberg Tax Research can help you untangle regulatory confusion and optimize your tax planning and strategy.