Under IRS rules, you may be able to claim a business bad debt deduction if you’re a business owner who has a worthless business debt on your books or a debt that has become uncollectible. Whether or not your bad debt can be considered a business or nonbusiness bad debt will depend upon a number of factors.
Determining Whether You Have a Business Bad Debt or a Nonbusiness Bad Debt
Business bad debts arise from losses that have been created or acquired in relation to your trade or business at the time it lost its value either partially or completely. Business loans to distributors, employees, suppliers or clients; business-related guarantees; and credit sales to customers if these have been included in the business’ income are some examples of what the IRS qualifies as a business bad debt. A business bad debt is deductible as an ordinary loss on your business tax return.
All other bad debts are considered nonbusiness and are reported as short-term capital loss. This type of debt can only be used to offset capital gains plus ordinary income up to $3,000. A deduction can only be taken for nonbusiness bad debts if the debt is completely worthless.
There are some situations in which your debts can be viewed as both a business bad debt and a nonbusiness, or personal, bad debt. For example, if you act as guarantor for a loan given to a supplier who is also a personal friend and the friend later defaults on that loan, your primary motivation for offering the loan may come into question. If your motivation is deemed to be primarily offered in the spirit of helping your friend, the debt will be considered nonbusiness bad debt. If it seems the guarantee was made primarily to help your business, it will be considered as a business bad debt. Similarly, you may be denied a business bad debt deduction if the IRS notes that the loan was made as a means of contributing to capital.
In order to successfully claim the bad debt deduction, you must have entered into the loan agreement or extended credit with the assumption that you would enforce collections if you failed to recoup the amount to be repaid. Keeping detailed documentation of these transactions is important so that you have a paper trail to refer back to if your bad debt deduction is called into question.
The Necessary Requirements for Deduction Eligibility
Because the business bad debt deduction is meant to offset prior tax liability, you are required to have included the receivable in your income in order to be eligible to take the deduction.
Not all of these types of debts will be deductible, however. For example, if your business relies upon the cash-basis method of accounting for accounts receivable, your business bad debt will not be deductible. Normally, those who pay taxes on a cash basis only report income when they receive payment and don’t include the amount of outstanding debts in their income. As they are omitting to report the bad debt in their income already, awarding these types of businesses an additional deduction for business bad debt would allow these taxpayers to doubly benefit.
Those who utilize the accrual basis for taxpaying report income as its earned, even if that income is paid at a future date, so a business bad debt deduction which may offset uncollectible amounts already included in the business’ income, may be allowed.
If you find yourself in a situation in which you have incurred business bad debt and are interested in learning more about whether you can claim it as a deduction, contact your Untracht Early advisor.