Businesses and individuals staring down the barrel of bad debt sometimes aren’t aware, overlook or don’t think they’re eligible to claim the bad debt as an income tax deduction. But a process exists by which this can be claimed; not granted, necessarily, but the possibility is there, assuming the business or personal loss qualifies under IRS rules.
The IRS defines business bad debts as follows: “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.” The amount of a bad debt is deducted from a business’s gross income in the year in which the deduction is being claimed. The pertinent consideration is that the IRS determines if it’s allowable.
Debts that are partially worthless may be eligible for a partial deduction. If the taxpayer has accounted for the debt as collectable only in part, the IRS may allow a deduction for the amount that remains uncollectable at the time the books on the debt were closed.
Bad debt deductions are made on the appropriate Schedule C IRS form or a business’s tax return.
The challenge in claiming the deduction is that the IRS’s means of determining whether a loan is wholly or in part worthless is somewhat less than objective, and a single factor may not be enough to show a worthless debt is eligible for a tax deduction. Another way to consider this is that a preponderance of accounting evidence is needed to prove the case. Documentation is crucial.
Also, the IRS makes a distinction between loans and gifts: a loan may qualify as a bad debt for deduction purposes, while a gift doesn’t qualify. Types of loans the IRS says can be considered for bad debt deductibility are loans to clients, suppliers, distributors or employees; credit sales to business customers; and business loan guarantees.
In a legal analysis, the IRS lists these factors as among those that indicate a business debt’s worthlessness:
- The debtor’s serious financial reverses
- Insolvency
- Lack of assets
- Continued refusal to respond to demands for payment
- Ill health
- Death
- Disappearance
- Abandonment of business
- Bankruptcy
- Unsecured or subordinated status
- Expiration of the statute of limitations
Sources for more detailed explanations of bad debt and business deductions are IRS publication Topic No. 453, Bad Debt Deduction, and 2021 Publication 535.
On the nonbusiness side, only completely worthless debts will be considered as a tax deduction: partially worthless debts are of no value as a tax break. Though the claimant must prove the debt is uncollectible, it’s not necessary, the IRS says, to have a court judgement entered against the debtor, though that would be powerful evidence. Nor is it necessary to wait until the debt becomes completely worthless, which could delay a potential tax benefit by pushing it into another tax year.
Nonbusiness debts are claimed as a short-term capital loss, and they're bound by limitations on capital losses. Additionally, there is a series of financial and reporting requirements that must be met. There are benchmarks the IRS uses to determine if any value is contained within the debt: collateral, third-party guarantees, the debtor’s ability to earn money to pay the debt and other factors affect identifying a nonbusiness debt as having become worthless.
As mentioned at the start, the ability to assess bad debt as a tax deduction is sometimes not something of which businesses and individuals take advantage. But it’s like this: if a good-faith attempt isn’t made, the answer is the same as being told no.
Perhaps, with the right documentation and circumstances, something bad (debt) can become something good (a tax deduction). Talk to an experienced accountant, tax attorney or financial advisor to explore your options.
This article first appeared in KnoxNews.
