Getting Tax Benefits From Bad Debts
© by Fred W. Daily
If you are self-employed long enough, you will be stiffed by a deadbeat. The
resulting bad debt may or may not be a tax-deductible item. Read on. (The full rule is in
the tax code and regulations, IRC § 166, Reg. 1.166.)
Business Bad Debt Rules
Lets get the bad news out of the way first: If you sell your services,
you cannot deduct an unpaid bill as a bad debt. No tax deduction is allowed for time you
devoted to the client or customer who doesnt pay. The tax code rationale is that if
you could deduct the value of unpaid services, it would be too easy to inflate your bills
and claim large bad debt deductionsand too hard for the IRS to catch you.
If your business provides goods, however, you can deduct the costs of any goods
sold, but not paid for, as an ordinary business expense. You cannot deduct any lost
profits you would have collected from the sale. The same rule holds if you actually lose
dollars. For instance, say you made a loan to a customer or client and didnt get
To get the deduction, there must have been a businessnot
personalreason for making the loan. And, you must have taken reasonable steps to
collect the debtsuch as making a written demand for payment, going to court or
turning the debt over to a collection agency.
Example: In 1997, Ralph and Rhondas incorporated print shop made a $2,000
loan to Susan, a friend and good customer, to keep her florist business afloat. Despite
this help, Susan went into bankruptcy in 1998 before making any repayment. Result: As long
as Ralph and Rhondas corporation made the loan to protect their business
relationshipand not just to help a friendthe bad debt is deductible for the
corporation in 1998.
Personal Bad Debt Rules
There are different tax rules for "non-business" bad debtsones
that dont qualify as business expenses. A bad debt in your personal life can still
produce a tax benefit, but under the much more restrictive short-term capital loss rules
for individuals. Generally, this means that a bad debt can be claimed on your personal tax
return first to offset any capital gains on investmentsand then up to another $3,000
max to offset your "ordinary" income from earnings.
To claim a non-business bad debt deduction, file Schedule D, Capital Gains and
Losses, with your tax return. A loan to Uncle Festus falls into this category, but not if
it was really a gift to get him into alcohol rehab and you never expected to get the money
back. To bulletproof the deduction, get a signed promissory note from Festus. Next be
ready to show the IRS you made some written efforts to try to collect on it. Expect an
auditor to be suspicious if a relative is involved in the tax deduction, unless you
qualify to claim old Festus as a dependent.
By: Frederick W. Daily, Tax Attorney,
John Raymond, Bankruptcy Attorney, and
Allan H. Rosenthal, paralegal.
All of the three have offices in San Francisco.
(This article was originally written for tax
practitioners who represent clients before the IRS. But the information
presented here is valuable for all taxpayers.)
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