CARL WATTS & ASSOCIATES

May 20, 2013



There are many kinds of debts, good and bad, but for tax purposes, there are two kinds of bad debt, business and nonbusiness.


Generally, if someone owes you money that you cannot collect, you may have a bad debt.

A business bad debt is one that comes from operating your trade or business, like loans to clients and suppliers, credit sales to customers, or business loan guarantees.

All other bad debts are nonbusiness.

You can claim a nonbusiness bad debt as a deduction on your personal income tax return if:

The debt is bona fide, meaning that there was a debtor-creditor relationship in which you made a loan that you intended and expected to be repaid. A simple loan document showing who's borrowing the money and how much, and when and how it's to be repaid will usually be enough to show a bona fide debt. In other words, you must demonstrate that the money could not be considered a gift.


You have a basis in the debt, meaning you've already included the amount in your income or loaned out your cash. Most people (as opposed to businesses) use the cash method of accounting. This means that you don't count items as "income" until you actually receive it. So, for example, you cannot take a bad debt deduction for alimony or wages you're not paid, even though it might be owed to you.

The debt is totally worthless. A debt becomes worthless when you know there's no chance you'll be repaid and you've taken reasonable steps to collect the debt. You may keep copies of letters demanding payment, make notes on phone calls you make to the debtor, save evidence that you have attempted to locate a debtor who has disappeared or documents showing the debtor has declared bankruptcy to establish your intent to pursue repayment and the debtor's refusal to pay or a lack of any response. You don't have to sue the borrower to prove that the debt's uncollectible, either. It's usually enough to show that the borrower filed bankruptcy after you made the loan.


To be deductible, the debt must be totally worthless. Unlike business bad debts, you can't take a deduction for partially worthless nonbusiness bad debts.


The deduction is characterized as a short-term capital loss that can be used to offset an unlimited amount of capital gains plus $3,000. Remaining amounts can be carried forward to successive tax years.


You can claim a non-business bad debt as a short-term capital loss on Form 8949 of your personal income tax return. You must include the debtor's name on Form 8949, part 1, line 1, and the words "bad debt statement attached" in column A.


In the attached statement you have to include the debtor's name again, a description of the debt, the amount due and the date it became due. Disclose any business or family relationship you have with the debtor, the efforts you made to collect the debt and an explanation of why you have determined the debt is worthless.


The IRS considers a business bad debt to be a loss from the worthlessness of a debt that was either created or acquired in your trade or business, or closely related to your trade or business when it became partly or totally worthless.

A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. Bad debts of a corporation (other than an S corporation) are always business bad debts.

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

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 would not 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 in accord with normal business practice or for a good faith business purpose.
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Bad Debt Deduction
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Business bad debts are mainly the result of credit sales to customers. Goods that have been sold, but not yet paid for, and services that have been performed, but not yet paid for, are recorded in your books as either accounts receivable or notes receivable. After a reasonable period of time, if you have tried to collect the amount due, but are unable to do so, the uncollectible part becomes a business bad debt.


You can claim a business bad debt deduction only if the amount owed to you was previously included in gross income. This applies to amounts owed to you from all sources of taxable income, including sales, services, rents, and interest.

If you use the cash method of accounting, you generally report income when you receive payment. You cannot claim a bad debt deduction for amounts owed to you because you never included those amounts in income. For example, a cash basis architect cannot claim a bad debt deduction if a client fails to pay the bill because the architect's fee was never included in income.

No tax deduction is allowed for time you devoted to the client or customer who doesn’t pay. The tax code rationale is that if you could deduct the value of unpaid services, it would be too easy to inflate your bills and claim large bad debt deductions.

If your business provides goods, however, you can deduct the costs of any goods sold, but not paid for, as an ordinary business expense. You cannot deduct any lost profits you would have collected from the sale.

If you use the accrual method of accounting, you generally report income as you earn it. You can only claim a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income.

There are two methods to claim a business bad debt.

  • The 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.

  • The nonaccrual-experience method. Under this method, you do not accrue service related income you expect to be uncollectible. Because the expected uncollectible amounts are not included in income, these amounts are not later deducted from income.

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. If your average annual gross receipts for any year exceeds $5 million, you cannot use the non-accrual experience method.

You report your business bad debt deductions on the appropriate tax form for the entity structure you operate the business under.