Business Bad Debt Defined

A business bad debt is a loss from the worthlessness of a debt that was either of the following.

• Created or acquired in your trade or business.
• Closely related to your trade or business when it became partly or totally worthless.

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

A debt is closely related to your trade or business if your primary motive for incurring the debt is a business reason.

Credit sales. Business bad debts are mainly the result of credit sales to customers. Goods and services customers have not paid for are shown in your books as either accounts receivable or notes receivable. If you are unable to collect any part of these accounts or notes receivable, the uncollectible part is a business bad debt. Accounts or notes receivable valued at fair market value at the time of the transaction are deductible only at that value, even though the fair market value may be less than face value.

You can take a bad debt deduction for these accounts and notes receivable only if the amount owed you was included in your gross income for the year the deduction is claimed or for a prior year. This applies to amounts owed you from all sources of taxable income, such as sales, services, rents, and interest.

If you qualify under certain rules, 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 expect to be uncollectible.

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

Cash method. If you use the cash method of accounting, you normally report income when you receive payment. You cannot take a bad debt deduction for amounts owed to you that you have not received and cannot collect because you never included those amounts in income.

Debts from a former business. If you sell your business but keep its accounts receivable, these debts are business debts since they arose in your trade or business. If an account becomes worthless, the loss is a business bad debt. These accounts 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 accounts receivable to someone else, the character of the debts as business or nonbusiness is based on the activities of the new holder of these debts. 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 debt of a business acquired from a decedent is determined in the same way as a debt 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.

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. His main reason for making these loans was to help his business. One of these clients later went bankrupt and could not repay him. Since John's business was the main reason for making the loan, the debt was a business debt and he 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 cannot take a bad debt deduction unless you use an accrual method of accounting and meet all the following tests.

1. The debt was from the sale of goods or services in the ordinary course of your trade or business.
2. More than 30% of all your receivables accrued in the year of the sale were from sales made 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 of the partnership's debts. If you pay any part of the insolvent partner's share of the debts, you can take a bad debt deduction.

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.

Consider any guarantee you make to protect or improve your job as closely related to your trade or business as an employee.

Example. Bob Zayne owns the Zayne Dress Company. He 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. Mr. Zayne made full payment to the bank. He can take a business bad debt deduction, since his guarantee was made in the course of his trade or business for a good faith business purpose. He was motivated by the desire to retain one of his better clients and keep a sales outlet.

Deductible in the year paid. You can deduct a payment you make on a loan you guaranteed in the year of payment 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.

Bankruptcy claim. You can deduct as a bad debt only the difference between the amount owed to you by a bankrupt entity and the amount you received from the distribution of its assets.

Sale of mortgaged property. If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt after the sale is a bad debt. If the debt represents capital or an amount you previously included in income, you can deduct it as a bad debt in the year it becomes totally worthless or in the year you charged it off as partially worthless.

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