If debt collection is a problem for your business, deducting uncollectible (bad) debts
from your tax bill may somewhat lessen the sting of simply writing the debt off your
books. Here is some basic information on deducting business bad debts.
First, the debt must be legitimate. A bona fide debt arises from a debtor-creditor
relationship and is based on a valid and enforceable obligation to pay a fixed or
determinable amount of money. For debt creation, the business must be able to show
that it was the intent of the parties at the time of the transfer to create a
debtor-creditor relationship. In other words, the business must be able to show that,
at the time of the transaction, there was a real expectation of repayment, and there
was intent to enforce the indebtedness.
While a formal loan agreement is not absolutely necessary to create a bona fide debt,
it is a good practice to use written debt agreements. However, giving a note or other
evidence of legally enforceable indebtedness is not by itself conclusive evidence of
a bona fide debt. For example, if the terms of the note are routinely ignored or
penalties for skipped or late payments are not enforced, the IRS could successfully
argue that there was not a real debt.
For most businesses, it is common to encounter uncollectible or worthless debts. Two
types of bad debt deductions are allowed by the IRS: business bad debts and
nonbusiness bad debts. Business bad debts give rise to ordinary losses that can
generally offset taxable income on a dollar-for-dollar basis. Nonbusiness (personal)
bad debts are considered to be short-term capital losses. Because there is a
limitation on deducting capital losses, distinguishing business and nonbusiness bad
debts is critical.
Business bad debts generally originate as credit sales to customers for goods
delivered or services provided. If a business sells goods or services on credit and
the account receivable subsequently becomes worthless, a business bad debt deduction
is permitted, but only if the revenue arising from the receivable was previously
included in income.
Business bad debts can also take the form of loans to suppliers, clients, employees,
and distributors. Additionally, a business bad debt deduction is allowed for any
payments made in the capacity as guarantor if the reason for guaranteeing the debt
was business related. Here, the guarantor's payment results in a loan to the debtor,
and the taxpayer is generally allowed a bad debt deduction once the loan becomes
partially or totally worthless.
Worthlessness can be established when the business sues the debtor, and then shows the
judgment is uncollectible. However, when the surrounding circumstances indicate a
debt is worthless and uncollectible, and that legal action to collect the debt would
in all probability not result in collection, proof of these facts is generally
sufficient to justify the deduction.
This publication is distributed with the understanding that the author, publisher and
distributor are not rendering legal, accounting or other professional advice or
opinions on specific facts or matters, and, accordingly, assume no liability
whatsoever in connection with its use. The information contained in this newsletter
was not intended or written to be used and cannot be used for the purpose of (1)
avoiding tax-related penalties prescribed by the Internal Revenue Code or (2)
promoting or marketing any tax-related matter addressed herein. © 2015