Business Bad Debts
A business bad debt is defined as a loss from an obligation that was either created or acquired in your trade or business or closely related to your trade or business when it became worthless. The bad debts of corporations are always business bad debts.
Generally, business bad debts arise from credit sales to customers for either the sale of goods or services. The uncollectible portion of a receivable is a business bad debt.
Deductibility of a Business Bad Debt
Whether or not a business bad debt is deductible depends on whether the amount owed was previously included in the taxpayer's gross income. This rule applies to all kinds of obligations owed to a business, including rents, interest, services, and sales.
In general, if you use the cash method of reporting income, you only report income when you receive a payment. Therefore, if you are a cash basis taxpayer, you cannot take a deduction for bad debts because you never included the amount of the debt in income.
A taxpayer who reports income using the accrual method of accounting includes income as it is earned rather than when it is received. Thus, an accrual method taxpayer is entitled to take a business bad debt deduction for uncollectible receivables already included in income. Under certain circumstances, an accrual method taxpayer does not have to include in gross income amounts billed for services already performed based on collection experience.
When is a Business Debt Worthless?
Fortunately, the Internal Revenue Service does not make a taxpayer wait until a business debt is due to determine whether or not it is worthless. A debt is worthless if there is no longer any chance that it can be collected. In order to show that a debt is worthless, the taxpayer must be able to prove that he has taken reasonable steps to collect it. However, he does not have to go to court if he can show that a judgment would be uncollectible. Bankruptcy of the debtor is good evidence that a business debt is worthless.
Types of Business Bad Debts
In addition to uncollectible receivables arising from the sale of goods or services, the following is a list of other transactions that might give rise to business bad debts.
- Loans to Customers or Suppliers. If these loans were made for a business reason and become worthless, they are business bad debts.
- Debts of Political Parties. A taxpayer who is owed money by a political party, he may take a deduction for a business bad debt only under certain circumstances.
- Business Loan Guarantee. Generally, a taxpayer who guarantees a debt that became worthless can take a deduction for a business bad debt if the guarantee was made in the course of business for a good faith business purpose.
- Joint Debtor. When a taxpayer is owed money jointly by two or more debtors, the taxpayer is not entitled to a business bad deduction simply because he cannot collect from one of the joint debtors.
- Bankruptcy of Debtor. A taxpayer who is owed money by a debtor who declares bankruptcy is entitled to a business bad deduction for the amount owed less any distribution from the bankrupt individual's assets.
- Capital Contribution. A taxpayer who loans money to a corporation is not entitled to a business bad debt deduction if the loan was in fact a contribution to capital.
Copyright 2011 LexisNexis, a division of Reed Elsevier Inc.