A bad debt is deductible for tax purposes if it is related to your trade or business. Bad debts may include accounts receivable from customers or clients that you cannot collect, and also loans or guarantees of loans that you make in the course of your trade or business. Different tax rules apply for partially and totally worthless debts.
When you have made sales or provided services on credit in your business, and you subsequently find that you are unable to collect on the account, you have a bad debt. Bad debts are business expenses and are deductible for U.S. income tax purposes.
Business Bad Debts
To be considered a bad debt and to be tax deductible, the debt must have been created or acquired in your trade or business, or it must have been closely related to your trade or business when it became partially or totally worthless. Closely related means that the primary motive for the debt was the conduct of your trade or business.
If you use the accrual method of accounting, the related account or note receivable must have been recorded on your business books when you earned the income. You cannot claim a deduction for a bad debt if the account that becomes worthless was never recorded as a receivable with the corresponding entry to income. This applies to your business as well as all other sources of taxable income. For example, if you have rental properties that do not necessarily constitute a business for you, but they generate taxable income, you can take a bad debt deduction only if you had included the rent in your income.
If you use the cash method for tax reporting, you would not have included the debt in your income, so you cannot claim it as a deductible expense when it becomes worthless.
When Is a Debt Worthless?
A debt is worthless when the facts and circumstances indicate that there is no longer any chance it will be paid. You must be able to show that you took all reasonable steps to collect the amount owed. But you do not necessarily have to wait until the debt actually becomes due if you have information indicating that it will not be paid. This does not necessarily mean the bankruptcy of the debtor, although that would be good evidence. And you do not have to take the debtor to court in order to claim a bad debt deduction.
A debt can be partially worthless. The portion that cannot be collected would qualify for a bad debt deduction, provided the total amount had been included in income. If property is received in partial payment of a debt, the amount owed is reduced by the fair market value of the property received. If that property is later sold, any gain on the sale is not considered a recovery of a bad debt. It would be reported as a gain on the sale of property, and could be ordinary income, or capital gain, depending on the circumstances. This gain would be taxable separately, regardless of whether or not any tax benefit was gained from the bad debt expense.
Types of Business Bad Debts
In addition to receivables from customers or clients that arise in the normal course of your trade or business, there are other situations that could result in a business bad debt deduction.
Loans that you make for business reasons, that become worthless, can be deducted as business bad debts. These include loans to suppliers and employees. Loans to customers or clients, other than trade receivables, also qualify if they become worthless.
If your business is a partnership, you may be able to claim a bad debt deduction if the partnership breaks up and you have to pay more than your share of the total debts because one of the other partners is insolvent.
You may also be able to claim a bad debt deduction if you guarantee a business debt that becomes worthless. In this case, the following tests must be met:
You made the guarantee in the course of your trade or business.
You have a legal obligation to pay as the guarantor of the debt.
You reasonably expected that you would not have to pay the debt when you made the guarantee.
You made the guarantee in accordance with normal business practice, or you had a good faith business purpose for making the guarantee. This could be the case, for example, if you guarantee a loan for a valued client, customer, supplier, or contractor, in the interest of your business.
Normally, if you guarantee a loan that you eventually have to repay, you can deduct the amount you have to pay as a bad debt in the year you pay it. But if you have rights against the borrower, this may not be the case. If as the guarantor of the debt, you have the right to demand payment from the borrower after you have paid the debt, you cannot claim a bad debt expense deduction until your rights against the borrower become worthless.
Methods for Treating Bad Debt Expenses
Generally you must use the specific charge-off method for bad debts. Under this method, you write off specific bad debts in the year they become worthless. Accounting practice provides a method for accruing bad debt expense, by setting up an allowance for doubtful accounts. This may be determined as a percentage of sales that, based on experience, will not be possible to collect. But this method is not allowed for income tax purposes. For tax purposes, each debt must be considered separately, and a bad debt expense deduction can be taken when only the debt becomes partially or totally worthless.
Partial Bad Debts
You can deduct part of a debt that becomes worthless and that you write off on your books. You do not necessarily have to charge off partially worthless debts on your books every year. You could delay the charge-off until a subsequent year, but you cannot take a deduction in a year after the debt becomes totally worthless.
If you claim a tax deduction for a part of a debt that you write off on your books, and the IRS disallows the deduction, you may still be able to claim the bad debt deduction in a subsequent year, when part of the debt actually becomes worthless. If you reversed the expense when the IRS disallowed the deduction, you would have to record the write-off again the year you claim the deduction. If you did not reverse the entry, you would take the tax deduction in the subsequent year and would have a timing difference between your bad debt expense for book and tax purposes for both years.
In order to claim a tax deduction for a partial bad debt, you have to write off that amount on your books. You do not necessarily have to write off a totally worthless debt on your books in order to be able to take the tax deduction. But if you do not, the IRS may determine that the debt is only partially worthless, and if you did not write off the debt on your books, you would not be able to claim a deduction for the partially worthless debt.
Amended Tax Return
If you did not claim a bad debt expense on your tax return for the year in which the debt became worthless, you cannot claim it in a subsequent year. But you can file an amended tax return for the year in which the debt became worthless in order to claim it. The form you use to file an amended return depends on how your business is set up. If you have a sole proprietorship you would use Form 1040X. A corporation would use Form 1120X. A partnership uses Form 1065, checking box G(5), and an S corporation uses Form 1120S, checking box F(5).
For a totally worthless debt, you must file an amended return by the later of 7 years from the date your original return was due, or 2 years from the date you paid the tax. For a partially worthless debt the amended return must be filed by the later of 3 years from the date you filed your original return, or 2 years from the date you paid the tax.
Non-Accrual Experience Method
If you meet certain requirements, you may be able to use the alternative non-accrual experience method for reporting bad debt expense. Under this method, if you keep your books using the accrual method of accounting, you do not accrue service-related income that you do not expect to be able to collect.
Generally you can use this method only if the services are in the fields of accounting, actuarial science, architecture, engineering, consulting, health, law, or the performing arts, or your average annual gross receipts for 3 prior tax years does not exceed $5 million.
If you claim a bad debt expense deduction and later recover all or part of the debt, you may have to include the amount recovered in your taxable income. You would normally include in income the amount you previously deducted. But you can exclude the amount deducted that did not reduce your tax. If you have to include the recovery, you would report it as Other Income on the appropriate line of your tax return.