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
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. taxmap/pubs/p535-054.htm#en_us_publink1000154203
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. taxmap/pubs/p535-054.htm#en_us_publink1000154204
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).taxmap/pubs/p535-054.htm#en_us_publink1000154205
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. taxmap/pubs/p535-054.htm#en_us_publink1000154206
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. taxmap/pubs/p535-054.htm#en_us_publink1000154207
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 10-1. Forms Used To File a
|IF you filed as a...||THEN file...|
|Sole proprietor or farmer|| Form 1040X|
|Corporation|| Form 1120X|
|S corporation|| Form 1120S|
(check box H(4))
|Partnership|| Form 1065 |
(check box G(5))
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.
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. taxmap/pubs/p535-054.htm#en_us_publink1000154212
You meet the gross receipts test if your average annual gross receipts for the 3 prior tax years does not exceed $5,000,000. taxmap/pubs/p535-054.htm#en_us_publink1000154213
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.
You can use any of the following nonaccrual-experience methods.
- Revenue-based moving average method.
- Actual experience method.
- Modified Black Motor method.
- Modified 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.