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Claiming Bad Debts on Uncollectible Receivables

In the normal course of business, companies are often obliged to extend credit to their customers and clients, some of whom will inevitably struggle to pay their bills. For those who do not pay, the Tax Code provides relief in the form of a deduction for business bad debts on receivables that result from the sale of goods and services and other business-related loans.

Business Bad Debt
You have a business bad debt if you cannot collect money owed to you in connection with your business. You can claim an ordinary deduction with regard to any business receivable in the year that it becomes totally or partially worthless, including debts that are not yet due as well as certain prior year loans. To claim the write-off, you must establish that the debt is genuine and that reasonable efforts to collect the debt have been exhausted. You are not required, however, to use a collection agency or file a lawsuit if doing so has little probability of success.

In most cases, a business bad debt may only be claimed if the amount owed to you was previously included in income under the accrual basis of accounting. Under the accrual method, all of your billings are recognized as income, regardless of whether they have been collected. By definition, therefore, taxable income already includes the billings from your non-paying customers. Once they are deemed uncollectible, a bad debt deduction is necessary in order to remove these customers from taxable income. This is referred to as the specific charge-off (or direct write-off) method, which requires that specific customer accounts be identified and charged off as partially or completely worthless.

Nevertheless, most small businesses with no inventory (inventory requires the accrual method) use the cash basis of accounting whereby income is not recognized until it is received. Since only receipt triggers income, there is no bad debt to deduct in the event that a customer does not pay (the cost of the goods or services you provided will have already been deducted when paid).

Consequently, business bad debts mainly result from credit sales to customers in the normal course of business. Cash-basis businesses do not have bad debts unless they make loans to a customer, supplier or employee with a closely related business purpose that, ultimately, become totally or partially worthless. Some examples include –

  • A building contractor who makes advances to a building material supplier, but never receives the supplies
  •  In order to retain a large customer, you make them a loan that is never repaid

In such cases, assuming you can prove the debt is worthless; a write-off may be claimed whether you are an accrual or cash-basis taxpayer.

Business Loan Guarantee
A loan that you guarantee that the borrower fails to repay can qualify as a business bad debt if all of 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 must have 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 accordance with normal business practice or for a good faith business purpose.


Tax Reporting for Business Bad Debts
The various business entities report a bad debt deduction as follows:

  • Self-employed taxpayers –
    • Schedule C, Profit or Loss from Business, Part V. Other Expenses
    • Schedule F (Profit or Loss from Farming), Line 32
  • C Corporations – Form 1120, U.S. Corporation Income Tax Return, Line 15
  • S Corporations – Form 1120S, U.S. Income Tax Return for an S Corporation, Line 10
  • Partnerships – Form 1065, U.S. Return of Partnership Income, Line 12


Non-Business Bad Debts
Some bad debts are personal in nature (i.e. no business connection or purpose), such as loans to individuals. As such, non-business bad debts are treated as short-term capital losses on Schedule D and are thereby limited to $3,000 ($1,500 for married filing separate taxpayers) per year in the absence of capital gains to offset additional losses. Any excess may be carried over to, and deducted in subsequent years subject to the $3,000/$1,500 annual limit.

Recoveries of Bad Debts
If you collect a receivable in a subsequent year that was written off in a previous year, it is considered a recovery of bad debts that is included in income in the year of collection. This is referred to as the tax benefit rule. Bad debt recoveries may not be offset against any current year bad debt deduction (they are each recorded broad on your tax return).

For more information, please contact Victor C. Belgiorno at 516-861-3704 or  or Bob Jahelka at 516-861-3707 or .

 
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