Publication 535 (2006), Business Expenses

10. Business Bad Debts

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Table of Contents

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 and 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 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.

Definition of business bad debt
When a debt becomes worthless
How to treat business bad debts
Recovery of a business bad debt

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 12 for information about getting publications and forms.

Definition of a 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.

Credit sales. 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.

Accrual method. 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.

Cash method. 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.

Liquidation. 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 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 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 paid the 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 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 claim 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.

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 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 unpreferred debt.

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.

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

Generally, you must use the specific charge-off method. However, you may 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 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).

Deduction disallowed. 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 the charge-off 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.

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 unable to manage your financial affairs due to a physical or mental impairment. Such an 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 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.

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, 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.

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.

Recovery of a Bad Debt

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.