Bad debts arise because money was loaned to a debtor or a customer received credit for purchasing a product or service, but the recipient could not fully or partially repay the debt. The following necessary factors determine the deductibility of bad debts:
The debt had no value, which means that there is little chance of receiving a partial or full amount
The taxpayer has suffered an economic loss as a result of the bad debt
There was a bonafide debtor-creditor relationship
There was a conscious effort to collect the debt,
A debtor-creditor relationship implies that the debtor has a legal obligation to repay the loan or pay for goods or services. Any loan agreement should state the loan amount, interest rate, due date, and payment schedule. Money given to a business must be credited as a loan under a loan agreement; otherwise, it can be treated as a non-deductible capital injection. There must be a genuine creditor-debtor relationship between the taxpayer and the debtor. If the taxpayer is related to the borrower, the IRS may treat the loan as a gift rather than an actual loan. To claim the default deduction, the transaction must have been made for a loan and not for a gift.
The worthlessness of the debt can be established by the debtor's insolvency or bankruptcy or by the futility of collecting the debt, such as suing the debtor or handing over the account to a debt collection agency proving that other reasonable steps have been taken to collect the debt. It is unnecessary to sue the debtor, but the taxpayer must prove that the decision is wrong. However, suppose the debtor is bankrupt due to bankruptcy. In that case, the default cannot be written off until the court has approved the reorganization, as the debt may have a value, depending on the reorganization.
If a collection agency is used, the collection agency's percentage can be deducted, as the taxpayer will not receive this amount. If a bad debt of $1,000 is transferred to a collection agency that charges 30%, $300 can be deducted when the debt is paid. The residual amount may be deducted when it is determined that it is uncollectible. Bankruptcy is usually good proof to indicate worthlessness for some of the unsecured or non-preferred debt. Keep in mind that worthless securities are not deducted as bad debts but as losses.
If no deduction has been claimed for a worthless debt when it has become worthless, the taxpayer has up to 7 years to file an amended return and claim the deduction.
Bad debt can only be subtracted if the taxpayer experiences an economic loss and only if it has been declared as income. If the bad debt is due to non-payment due to extending credit for a product, the debt is not deducted. The loss is accounted for only as of the cost of goods and other expenses related to the product's production. If the services were provided but not paid for, the deduction of bad debts is not allowed, as only economic losses are deductible. Whether the taxpayer spent time and effort providing the service or incurred an opportunity cost does not affect the deduction's disallowance. However, the costs incurred to provide the service can still be deducted.
A cash-basis business will generally not have bad debt, as income is not recognized until it is received. If the income is not included in the tax return, there is no deduction for bad debts. For example, if a landlord cannot collect rent from a tenant, the taxpayer cannot deduct the unpaid rent because it will not be reported as rent. If the landlord uses the accrual accounting method, it can only be implicitly deducted if the income has already been declared; otherwise, the taxpayer may simply eliminate the unearned income from the accumulated income.
Business and Non-Business Bad Debts
The tax rules that apply to the bad debts vary depending on whether it is commercial or non-commercial.
Business Bad Debt
A business's bad debt must be related to the business, and there must be a business reason for the debt. Bad debts generally occur in the form of credit sales to customers, which are recorded as receivables, or loans to suppliers or distributors, customers, or employees, which are recorded as receivables. Uncollectible receivables or notes are considered as bad debts of the business.
Suppose a partner needs to make payments on other partners' debts or partnerships that exceed the partner's debt ratio. In that case, the partner can deduct payments for any collected debt, which can be deducted as a bad business debt by the partner. Business deductions can be claimed even after the business ends.
Nonbusiness Bad Debt
Non-business bad debt is debt that is not a bad business debt, whether personal or investment-related. A partial loss of bad business debt can be deducted; however, only the total loss resulting from non-commercial bad debt can be deducted; no partial deduction is allowed.
Bad debts from businesses can be deducted as normal losses. Non-business bad debts are deducted as short-term capital losses which can offset capital gains; if the result is a net capital loss, it can be used to offset up to $3,000 ($ 1,500, if married filing separately) of other income; any residual loss can be reported as a short-term capital loss.
Reporting bad debts
When individual taxpayers report bad debt but not business entities, such as a corporation or a partnership, additional information should be provided in a separate statement:
Debt collection efforts
Description of the debt
Family or business relationship with the debtor, if there is a relationship, it may not be considered a bona fide debt.
How the worthlessness of the debt was determined
Loan maturity
The name of the debtor
Business bad debts are reported on tax forms, such as Schedule C. If a bad debt is eventually recovered, the company simply adds it to revenue for the year it was recovered and you don't need to file an amended tax return.
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