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. taxmap/pubs/p535-052.htm#TXMP25871c58
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 12 for information about getting publications and forms.taxmap/pubs/p535-052.htm#en_us_publink1000154180
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.taxmap/pubs/p535-052.htm#en_us_publink1000154181
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.
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. taxmap/pubs/p535-052.htm#en_us_publink1000154184
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. taxmap/pubs/p535-052.htm#en_us_publink1000154185
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. taxmap/pubs/p535-052.htm#en_us_publink1000154186
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. taxmap/pubs/p535-052.htm#en_us_publink1000154187
If you liquidate your business and some of your accounts receivable become worthless, they become business bad debts.taxmap/pubs/p535-052.htm#en_us_publink1000154188
The following are situations that may result in a business bad debt.taxmap/pubs/p535-052.htm#en_us_publink1000154189
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. taxmap/pubs/p535-052.htm#en_us_publink1000154190
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.
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. taxmap/pubs/p535-052.htm#en_us_publink1000154192
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. taxmap/pubs/p535-052.htm#en_us_publink1000154193
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.
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.taxmap/pubs/p535-052.htm#en_us_publink1000154195
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. taxmap/pubs/p535-052.htm#en_us_publink1000154196
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. taxmap/pubs/p535-052.htm#en_us_publink1000154197
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. taxmap/pubs/p535-052.htm#en_us_publink1000154198
If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt.