Publication 535: Business Expenses; Chapter 11

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Table of Contents

Introduction

If someone owes you money you cannot collect, you have a bad debt. There are two kinds of bad debts—business and nonbusiness. This chapter covers 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 tax return.

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 treat business bad debts
Recovery of a business bad debt
Where to deduct business bad debts

Useful Items - You may want to see:

Publication

525 Taxable and Nontaxable Income
536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
544 Sales and Other Dispositions of Assets
550 Investment Income and Expenses
556 Examination of Returns, Appeal Rights, and Claims for Refund

See chapter 14 for information about getting publications and forms.

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 2003, Arnie died leaving his business, including the accounts receivable, to his son Carl. Certain receivables become worthless in 2004. 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 2003, Charlie died leaving his business to his son George, but leaving the receivables to his daughter Diane. The receivables become worthless in 2004. Diane is not engaged in any trade or business during 2003 or 2004. 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.

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 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.

When Debt Is 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 unpreferred debt.

Property received for debt. If you receive property in partial settlement of a debt, reduce the debt by the fair market value 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.

Example.

Patti owed Margaret $5,000. In partial satisfaction of the debt, Patti gave Margaret property worth $2,000. Margaret deducted the remaining $3,000 as a bad debt but did not get a tax benefit from the deduction as she had no taxable income. Margaret later sold the property for a $1,000 gain. Even though Margaret did not get a tax benefit from the earlier bad debt deduction, she must include the $1,000 gain in her income. It is not a recovery of her bad debt.

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

IF you filed as a...	THEN file...
Sole proprietor or farmer	Form 1040X
Corporation	Form 1120X
S corporation	Form 1120S (check box F(5))
Partnership	Form 1065 (check box G(5))

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 service related income you expect to be uncollectible.

You generally 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, or the 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 $5,000,000.

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.

Methods available. You can use any of the following nonaccrual-experience methods.

6-year moving average method.
Actual experience method.
Modified Black Motor method.
Modified 6-year moving average method.
Alternative nonaccrual-experience method.

Apply the nonaccrual-experience method separately to each account receivable.

You generally 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 section 1.448-2T(g) of the regulations for more information on obtaining consent to change to a nonaccrual-experience method or to change from one method to another.

For more information about the nonaccrual-experience method, including the $5 million gross receipts test, see section 448(d)(5) of the Internal Revenue Code and section 1.448-2T of the regulations.

Recovery

If you deduct a bad debt on your 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.

More information. See Publication 536 for more information about net operating losses.

Where To Deduct

Use the following table to find where to deduct your business bad debts.

Table 11-2. Where To Deduct a Bad Debt

IF you file as a...	THEN deduct your bad debt on...
Sole proprietor	Line 27 of Schedule C (Form 1040)
Farmer	Line 34 of Schedule F (Form 1040)
Corporation	Line 15 of Form 1120 or Form 1120-A
S corporation	Line 10 of Form 1120S
Partnership	Line 12 of Form 1065

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Chapter 11 - Business Bad Debts