Question

1. How does the IRS define “business bad debt” and “nonbusiness bad debt” so that a taxpayer or a return preparer can distinguish between the two? What criteria or specific examples does the IRS give to aid in making the distinction?
2. The IRS states that there are two methods that can be used for claiming a business bad debt deduction (other than for a business bad debt of an employee). Describe these two methods.

Please answer each question in complete sentences, and cite name and number of the IRS publication or form/instruction where you found each answer, and the page number on which the answer is found. Use your own words in the answer – do not copy the IRS’ language.

Answer 1

If someone owes you money that you can't collect, you may have a bad debt. For a discussion of what constitutes a valid debt, refer to Publication 550, Investment Income and Expenses and Publication 535, Business Expenses. Generally, to deduct a bad debt, you must have previously included the amount in your income or loaned out your cash. If you're a cash method taxpayer (most individuals are), you generally can't take a bad debt deduction for unpaid salaries, wages, rents, fees, interests, dividends, and similar items. For a bad debt, you must show that at the time of the transaction you intended to make a loan and not a gift. If you lend money to a relative or friend with the understanding the relative or friend may not repay it, you must consider it as a gift and not as a loan, and you may not deduct it as a bad debt.

There are two kinds of bad debts – business and non business.

Business Bad Debts - Generally, a business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless. A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. You can deduct it on Form 1040, Schedule C, Profit or Loss from Business (Sole Proprietorship) or on your applicable business income tax return.

The following are examples of business bad debts (if previously included in income):

• Loans to clients, suppliers, distributors, and employees
• Credit sales to customers, or
• Business loan guarantees

A business deducts its bad debts, in full or in part, from gross income when figuring its taxable income.

Nonbusiness Bad Debts - All other bad debts are nonbusiness. Non business bad debts must be totally worthless to be deductible. You can't deduct a partially worthless non business bad debt.

A debt becomes worthless when the surrounding facts and circumstances indicate there's no reasonable expectation that the debt will be repaid. To show that a debt is worthless, you must establish that you've taken reasonable steps to collect the debt. It's not necessary to go to court if you can show that a judgment from the court would be uncollectible. You may take the deduction only in the year the debt becomes worthless. You don't have to wait until a debt is due to determine that it's worthless.

Report a nonbusiness bad debt as a short-term capital loss on Form 8949, Sales and Other Dispositions of Capital Assets , Part 1, line 1. Enter the name of the debtor and "bad debt statement attached" in column (a). Enter your basis in the bad debt in column (e) and enter zero in column (d). Use a separate line for each bad debt. It's subject to the capital loss limitations. A nonbusiness bad debt deduction requires a separate detailed statement attached to your return. The statement must contain: a description of the debt, including the amount and the date it became due; the name of the debtor, and any business or family relationship between you and the debtor; the efforts you made to collect the debt; and why you decided the debt was worthless.

For information on nonbusiness bad debts, refer to Publication 550, Investment Income and Expenses (PDF). For information on business bad debts, refer to Publication 535, Business Expenses.

Types of Business Bad Debts

Business bad debts may result from the following.

Loans to clients and suppliers.

If you loan money to a client, supplier, employee, or distributor for a business reason and you’re unable to collect the loan after attempting to do so, you have a business bad debt.

Debts owed by 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 all of the following requirements are met.

1. You use an accrual method of accounting.

2. The debt arose from the sale of goods or services in the ordinary course of your trade or business.

3. More than 30% of your receivables accrued in the year of the sale were from sales to political parties.

4. 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 of the partnership's debts. 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 wouldn’t have to pay the debt without full reimbursement from the borrower.

• You received reasonable consideration for making the guarantee. You meet this requirement if you made the guarantee according to 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. 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 because 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 can’t 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 doesn’t 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.

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. However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the 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 don’t have to charge off and deduct your partly worthless debts annually. You can delay the charge-off until a later year. However, you can’t 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 that 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 doesn’t allow your deduction and the debt becomes partly worthless in a later tax year, you can deduct the amount you charged 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 minus any amount deducted in an earlier tax year when the debt was only partly worthless.

You don’t 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 don’t and the IRS later rules the debt is only partly worthless, you’ll not be allowed a deduction for the debt in that tax year because a deduction of a partly worthless bad debt is limited to the amount actually charged off. See Partly worthless debts , earlier.

Filing a claim for refund.

If you didn’t 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.

Nonaccrual-Experience Method

Generally, a person using accrual accounting isn’t required to accrue a service-provided receivable that experience shows won't be collected if:

• The service provided is health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or

• The person's average annual gross receipts for all previous 3‐tax‐year periods don't exceed $25 million.