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Every uncollected debt will cost you money, but many business debts can be claimed as tax deductions—if you’re careful.
By Mark E. Battersby
What business owner hasn’t suffered from customers that do not or cannot pay? Accounts receivable are not always collected in full for a variety of reasons. Sometimes customers simply evade payment, and the cost of pursuing them is more than the recoverable amount would be; sometimes, customers become bankrupt and aren’t required to pay; sometimes the debt becomes time-barred. (Debt collectors have a limited number of years—known as the statute of limitations—to sue to collect.)
Essentially, no matter how hard you try, it’s just not always possible to bring all customer accounts to zero—even after friendly attempts at collection, when you haven’t received the total amount owed and suspect that you never will. At that point, you have a choice: Write off the account as a bad debt, or forgive the debt entirely. Each approach carries trade-offs.
Forgive it, or write it off?
Some small businesses simply forgive the outstanding debts of customers who may have fallen on hard times. Unfortunately, there is no tax deduction associated with this type of bookkeeping adjustment.
However, you may be able to deduct business bad debts as an expense on your business tax return. The debt must have been created or acquired in the normal course of business or closely related to the business when it became either partly or totally worthless. That usually includes goods and services that haven’t been paid for by customers. In other words: your basic accounts receivable or notes receivable.
Business bad debts may be deducted in part or in full. Nonbusiness bad debts must be totally worthless to be deductible, and if allowed deductible by the IRS, they would be treated as a short-term capital loss—limited to $3,000 per year.
Good bad debts
A bad debt is usually defined as an account or note receivable that has proven to be entirely or partially uncollectable despite collection efforts. Just because something may be labeled as a business bad debt, however, doesn’t necessarily make it tax deductible.
A bad debt deduction can be claimed only if the amount owed was included in gross income for the year the deduction is claimed, or for a prior year. This is almost never the case for cash method businesses (that means most fabricators or suppliers who report income when it’s received). Accrual method fabricators and suppliers, however, report income as it’s earned; if receivables have already been claimed as income, a bad debt deduction for uncollectible receivables is appropriate.
Business bad debts
A business bad debt is a loss resulting from the worthlessness of a debt that was either:
- created or acquired in a trade or business, or
- closely related to the trade or business when it became partly or totally worthless.
A debt is closely related to a trade or business if the primary motive for incurring the debt is business related. Bad debts of an incorporated specialty fabric products business (other than an S corporation) are always business bad debts.
Business bad debts are usually 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 the books as either accounts receivable or notes receivable. After a reasonable period of time, if attempts have been made to collect the amount due but were unsuccessful, the uncollectible portion becomes a business bad debt.
Under current tax rules, 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 an account receivable was purchased for less than its face value, and that receivable subsequently becomes worthless, the most allowed as a tax deduction is the amount paid to acquire it.
When money is loaned to a customer, supplier, employee or distributor for a business reason and the operation is unable to collect the amount after attempting to do so, that is a business bad debt. Note, however, that a bad debt deduction for a loan made to a corporation cannot be claimed if, based on the facts and circumstances, the loan is actually a contribution to capital. (A cash transfer is treated as a loan if there is an unconditional obligation to repay it.)
What qualifies?
If a business guarantees a debt that subsequently becomes worthless, that debt can qualify as a business bad debt if all of the following requirements are met:
- The guarantee was made in the course of the trade or business.
- A legal duty to pay the debt exists.
- The guarantee was made before the debt became worthless. This requirement is met where there was a reasonable expectation that the debt would not have to be paid without full reimbursement from the borrower.
- If reasonable consideration for making the guarantee was received. This requirement is met if the guarantee was made in accord with normal business practice or for a good faith business purpose.
Generally, a debt becomes worthless when the surrounding facts and circumstances indicate that there is no reasonable expectation of payment. To show that a debt is worthless, a business must establish that it has taken reasonable steps to collect the debt. (It is not necessary to go to court if it can be shown that a judgment from the court would be uncollectible.)
Also, as previously mentioned, the deduction can be claimed only in the year that the debt becomes worthless. It is not necessary to wait until a debt is due to determine whether it is worthless. Bankruptcy of the debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.
Recovering bad debts
If a deduction for a bad debt is claimed on an income tax return and later all or part of the debt is recovered (collected), all or part of the recovery amounts may have to be included in the business’s gross income. Fortunately, the amount that must be included is limited to the amount actually deducted. The amount deducted that did not reduce the tax bill can usually be excluded.
If property is received in partial settlement of a debt, that debt is reduced by the property’s fair market value, which becomes the property’s basis or book value. The remaining debt can be deducted as a bad debt if and when it becomes worthless. Should the property later be sold for more than its basis, any gain on the sale is due to the appreciation of the property; it is not a recovery of a bad debt.
Besides costing your business money, bad debts complicate accounting. When using accrual-basis accounting (as many businesses do), income is realized at the time of sale, not when it is actually received. Because of the time lag as the nonpaid sale becomes an overdue account, many businesses go through various collection procedures, and the overdue account may eventually become a bad debt deductible on the business’s tax return.
For that to happen, the business must be able to show the debt is partially or totally worthless. Tax law doesn’t allow a deduction for any part of a debt after the year in which it becomes totally worthless. To ensure that your business doesn’t miss out on a bad debt deduction in the current tax year, records should be reviewed carefully to pinpoint any potentially worthless receivables still carried on the books. It’s also a wise move to make sure that all failed collection efforts are carefully documented in case the IRS challenges the bad debt deduction.
This area of tax law requires substantiation, and can be tricky. If you have questions, be sure to check with your tax professional before assuming that a bad debt is also tax deductible.