Business Bad Debt Defined

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.

The bad debts of a corporation are always business bad debts.

Credit sales. Business bad debts are mainly the result of credit sales to customers. Goods and services customers have not paid for are recorded in your books as either accounts receivable or notes receivable. If you are unable to collect any part of these receivables, the uncollectible part is a business bad debt.

Accounts or notes receivable valued at fair market value when received are deductible only at that value, even though the fair market value may be less than face value. If you bought an account receivable for less than its face value, the amount you can deduct if it becomes worthless is the amount you paid for it.

You can take a bad debt deduction only if the amount owed you was previously included in gross income. This applies to amounts owed you from all sources of taxable income, including sales, services, rents, and interest.

Accrual method. If you use an accrual method of accounting, you generally report income as you earn it. You can only take a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income.

If you qualify, you can use the nonaccrual-experience method of accounting discussed later. Under this method, you do not have to accrue income that, based on your experience, you do not expect to collect.

Cash method. If you use the cash method of accounting, you generally report income when you receive payment. You cannot take a bad debt deduction for amounts owed to you because you never included those amounts in income. For example, a cash basis architect cannot take a bad debt deduction if a client does not pay the bill because the architect's fee was not previously included in income.

Debts from a former business. If you sell your business but keep its receivables, these debts are business debts since they arose out of your trade or business. If one of these debts later becomes worthless, the loss is still a business bad debt. These debts would also be business debts if sold to the new owner of the business.

If you sell your business to one person and sell your receivables to someone else, the activities of the new holder of the debts determine whether they are business or nonbusiness debts for that person. A loss from the debts is a business bad debt to the new holder if that person acquired the debts in his or her trade or business or if the debts were closely related to the new holder's trade or business when they became worthless. Otherwise, a loss from these debts is a nonbusiness bad debt.

Debt acquired from a decedent. The character of a loss from debts of a business acquired from a decedent is determined in the same way as debts sold by a business. If you are in a trade or business, a loss from the debts is a business bad debt if the debts were closely related to your trade or business when they became worthless. Otherwise, a loss from these debts is a nonbusiness bad debt.

Example 1. In 2000 Arnie died, leaving his business, including the accounts receivable, to his son Carl. Certain receivables become worthless in 2001. Carl can deduct the loss as a business bad debt because the debt was closely related to his business when it became worthless.

Example 2. In 2000 Charlie died, leaving his business to his son George, but leaving the receivables to his daughter Diane. The receivables become worthless in 2001. Diane is not engaged in any trade or business during 2000 or 2001. Therefore, Diane's loss is a nonbusiness bad debt even though the original debt was incurred in a business.

Liquidation. If you liquidate your business and some of your accounts receivable become worthless, they are 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 make a loan to a client, supplier, employee, or distributor for a business reason and it becomes worthless, you have a business bad debt.

Example. John Smith, an advertising agent, made loans to certain clients to keep their business. One of these clients went bankrupt and could not repay him. Since the main reason for making the loan was business related, the debt was a business debt and John can take a business bad debt deduction.

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 take 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 continuing efforts to collect on the debt.

Loan or capital contribution. You cannot take 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 is insolvent and cannot pay any of the partnership's debts, you may have to pay more than your share. If you pay any part of the insolvent partner's share of the debts, you can take a bad debt deduction for the amount you pay.

Business loan guarantee. If you guarantee a debt that becomes worthless, the debt can qualify as a business bad debt if all the following requirements are met.

• You made the guarantee in the course of your trade or business.
• You have a legal duty to pay the debt.
• 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.
• 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.

Example. Jane Zayne owns the Zayne Dress Company. She guaranteed payment of a $20,000 note for Elegant Fashions, a dress outlet. Elegant Fashions is one of Zayne's largest clients. Elegant Fashions later filed for bankruptcy and defaulted on the loan. Ms. Zayne made full payment to the bank. She can take a business bad debt deduction, since her guarantee was made in the course of her trade or business for a good faith business purpose. She was motivated by the desire to retain one of her better clients and keep a sales outlet.

Employee. Any guarantee you make to protect or improve your job is closely related to your trade or business as an employee.

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 take 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.

Bankruptcy claim. If a person who owes you money becomes bankrupt, the amount you can deduct as a bad debt is the amount owed to you minus the amount you receive from distribution of the bankrupt person's assets.

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.

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