How To Treat

There are two ways to treat business bad debts.

• The specific charge-off method.
• The nonaccrual-experience method.

Generally, you must use the specific charge-off method. However, you can 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. 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. You cannot, however, 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 section 1.166-(3)(a)(3) of the regulations.

Deduction disallowed. You can generally take 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, you can deduct the entire amount, except 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.

• 3 years from the date you filed your original return.
• 2 years from the date you paid the tax.

You may have longer to file the claim if you were physically or mentally unable to handle your financial affairs for a time. For details and more information about filing a claim, see Publication 556.

Use one of the following forms to file a claim.

Table 11-1. Forms Used To File a
      Claim

Nonaccrual-Experience Method

If you use an accrual method of accounting and qualify under the rules explained in this section, you can use the nonaccrual-experience method for bad debts. Under this method, you do not accrue income you expect to be uncollectible.

If you determine, based on your experience, that certain amounts (accounts receivable) are uncollectible, do not include them in your gross income for the tax year.

Amounts must be for performing services. You can use the nonaccrual-experience method only for amounts earned by performing services. You cannot use this method for amounts owed to you from activities such as lending money, selling goods, or acquiring receivables or other rights to receive payment.

Interest or penalty charged. Generally, you cannot use the nonaccrual-experience method for amounts due on which you charge interest or a late payment penalty. However, do not treat a discount offered for early payment as the charging of interest or a penalty if both the following apply.

• You otherwise accrue the full amount due as gross income at the time you provide the services.
• You treat the discount allowed for early payment as an adjustment to gross income in the year of payment.

How to apply this method. You can apply the nonaccrual-experience method under either of the following systems.

• Separate receivable system.
• Periodic system.

Under the separate receivable system, apply the nonaccrual-experience method separately to each account receivable. Under the periodic system, apply the nonaccrual-experience method to total qualified accounts receivable at the end of your tax year.

Treat each of these systems as a separate method of accounting. You generally cannot change from one system to the other without IRS approval.

Generally, you also need IRS approval from a different accounting method to either system under the nonaccrual-experience method.

For more information on the separate receivable system, see section 1.448-2T of the regulations. For more information on the periodic system, see Notice 88-51 in Cumulative Bulletin 1988-1.

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