||2008 Tax Year
If someone owes you money that you are not going to be able to collect, you have a bad debt. There are two kinds of bad debts—business
nonbusiness. This chapter discusses only business bad debts.
Generally, a business bad debt is one that comes from operating your trade or business. You can deduct business bad debts
on your business income
All other bad debts are nonbusiness bad debts and are deductible only as short-term capital losses on Schedule D (Form 1040).
For more information
on nonbusiness bad debts, see Publication 550.
Topics - This chapter discusses:
Definition of business bad debt
When a debt becomes worthless
How to claim a business bad debt
Recovery of a bad debt
Useful Items - You may want to see:
Taxable and Nontaxable Income
Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
Sales and Other Dispositions of Assets
Investment Income and Expenses
Examination of Returns, Appeal Rights, and Claims for Refund
See chapter 12 for information about getting publications and forms.
Definition of Business Bad Debt
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. Bad
debts of a corporation
are always business bad debts.
Business bad debts are mainly the result of credit sales to customers. Goods that have been sold, but not yet paid
for, and services that have been
performed, but not yet paid for are recorded in your books as either accounts receivable or notes receivable. After a reasonable
period of time, if
you have tried to collect the amount due, but are unable to do so, the uncollectible part becomes a business bad debt.
Accounts or notes receivable valued at fair market value (FMV) when received are deductible only at that value, even
though the FMV may be less
than the face value. If you purchased an account receivable for less than its face value, and the receivable subsequently
becomes worthless, the most
you are allowed to deduct is the amount you paid to acquire it.
You can claim a bad debt deduction only if the amount owed to you was previously included in gross income. This applies to
amounts owed to you from
all sources of taxable income, including sales, services, rents, and interest.
If you use the accrual method of accounting, generally, you report income as you earn it. You can only claim a bad
debt deduction for an
uncollectible receivable if you have previously included the entire 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.
If you use the cash method of accounting, generally, you report income when you receive payment. You cannot claim
a bad debt deduction for amounts
owed to you because you never included those amounts in income. For example, a cash basis architect cannot claim a bad debt
deduction if a client
fails to pay the bill because the architect's fee was never included in income.
Debts from a former business.
If you sell your business but retain its receivables, these debts are business debts because they arose out of your
trade or business. If any of
these receivables subsequently become worthless, the loss is still a business 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. The executor
of the decedent's estate treats any loss from the debts as a business bad debt if the debts were closely related to the decedent's
trade or business
when they became worthless. Otherwise, a loss from these debts becomes a nonbusiness bad debt for the decedent's estate.
If you liquidate your business and some of your accounts receivable become worthless, they become 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 loan money to a client, supplier, employee, or distributor for a business reason and subsequently, after making
attempts to collect, the
loan receivable becomes worthless, you have a business bad debt.
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 claim a bad debt deduction only if you use an accrual method of accounting and meet all the following tests.
The debt arose from the sale of goods or services in the ordinary course of your trade or business.
More than 30% of your receivables accrued in the year of the sale were from sales to political parties.
You made substantial and continuing efforts to collect on the debt.
Loan or capital contribution.
You cannot claim 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 becomes insolvent, you may have to pay more
than your pro rata share. If you
pay any part of the insolvent partner's share of the debts, you can claim a bad debt deduction for the amount you paid that
is attributable to the
insolvent partner's share.
Business loan guarantee.
If you guarantee a debt that subsequently 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
business practice or for a good faith business purpose.
Jane Zayne owns the Zayne Dress Company. She guaranteed payment of a $20,000 note for Elegant Fashions, a dress outlet that
is not a “related
person.” Elegant Fashions is one of Zayne's largest clients. Elegant Fashions later defaulted on the loan. As a result, Ms. Zayne
remaining balance of the loan in full to the bank.
She can claim a business bad debt deduction only for the amount she paid, 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.
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
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 claim a bad debt deduction until these rights
become partly or totally
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
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.
When a Debt Becomes Worthless
You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no
longer any chance the
amount owed will be paid.
It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You must only show
that you have taken
reasonable steps to collect the debt. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least
a part of an unsecured and
Property received for debt.
If you receive property in partial settlement of a debt, reduce the debt by the FMV of the property received. You
can deduct the remaining debt as
a bad debt if and when it becomes worthless.
If you later sell the property, any gain on the sale is due to the appreciation of the property. It is not a recovery
of a bad debt. For
information on the sale of an asset, see Publication 544.
How To Claim a Business Bad Debt
There are two methods to claim a business bad debt.
Generally, you must use the specific charge-off method. However, you may use the nonaccrual-experience method if you meet
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
Partly worthless debts.
You can deduct specific bad debts that become partly uncollectible during the tax year. 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. However, you cannot 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 Regulations section 1.166-(3)(a)(3).
Generally, you can claim 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
requirement for the later year.
Totally worthless debts.
If a debt becomes totally worthless in the current tax year, you can deduct the entire amount, less 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.
If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates.
You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment.
impairment requires proof of existence. See Code section 6511(h).
For details and more information about filing a claim, see Publication 556. Use one of the following forms to file
Table 10-1. Forms Used To File a Claim
|IF you filed as a...
Sole proprietor or farmer
(check box H(4))
(check box G(5))
If you use an accrual method of accounting and qualify under the rules explained in this section, you can use the nonaccrual-experience
bad debts. Under this method, you do not accrue service related income you expect to be uncollectible.
Generally, you can use the nonaccrual-experience method for accounts receivable for services you performed only if:
The services are provided in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law,
performing arts, or
You meet the $5 million gross receipts test for all prior years.
Service related income.
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.
Gross receipts test.
You meet the gross receipts test if your average annual gross receipts for the 3 prior tax years does not exceed
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 can use any of the following nonaccrual-experience methods.
Revenue-based moving average method.
Actual experience method.
Modified Black Motor method.
Modified moving average method.
Alternative nonaccrual-experience method.
Apply the nonaccrual-experience method separately to each account receivable.
Generally, you cannot change from one method to another without IRS approval. You may be able to obtain automatic
consent to change your method of
accounting. See Regulations section 1.448-2 for more information on obtaining consent to change to a nonaccrual-experience
method (other than one of
the safe harbor methods) or to change from one method to another.
For more information about the nonaccrual-experience method, including the $5 million gross receipts test, see Code
section 448(d)(5) and
Regulations section 1.448-2.
If you claim a deduction for a bad debt on your income tax return and later recover (collect) all or part of it, you may have
to include all or
part of the recovery in gross income. The amount you include is limited to the amount you actually deducted. However, you
can exclude the amount
deducted that did not reduce your tax. Report the recovery as “Other income” on the appropriate business form or schedule.
See Recoveries in Publication 525 for more information.
Net operating loss (NOL) carryover.
If a bad debt deduction increases an NOL carryover that has not expired before the beginning of the tax year in which
the recovery takes place, you
treat the deduction as having reduced your tax. A bad debt deduction that contributes to a net operating loss helps lower
taxes in the year to which
you carry the net operating loss. See Publication 536 for more information about net operating losses.
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