Bad Debts in General

If you cannot collect money that is owed to you in your business, your loss may be deductible. You must prove 3 factors to establish a bad debt:

1. The debtor-creditor relationship
2. Worthlessness
3. Loss

The Debtor-Creditor Relationship

You must prove that there is a debtor-creditor relationship. This means that there is a legal obligation on the part of the debtor to pay to the creditor (you) a fixed or determinable sum of money. The legal obligation can arise from making a loan or selling goods and services.

If you lend money to a friend or relative, the relationship between you and the borrower is not always clear. You may, for example, lend the money with the expectation of receiving repayment but later forgive some or all of the payments. This forgiveness with a friend or relative transforms what might have been a bad debt into a gift. The law does not bar loans between relatives or friends, but be aware that the IRS gives special scrutiny to loans involving related parties.

The simplest way to prove a debtor-creditor relationship is to have a written note evidencing the loan. The note should state the following terms:

  • The amount of the loan
  • A stated rate of interest
  • A fixed maturity date
  • A repayment schedule

If you have a corporation to which you lend money, establishing the debtor-creditor relationship is crucial. Unless you can show that an advance to the corporation is intended to be a loan, it will be treated as a contribution to the capital of the corporation (which is not deductible). Make sure that not only do you have a written note stating the terms of the loan (rate of interest, repayment schedule, etc.), but also that the corporation carries the advance as a loan on its books.

If your corporation lends money to others, it is advisable to include this arrangement in the corporate minutes (e.g., a corporate resolution authorizing the loan and spelling out the loan terms) as well as to carry the loan on the corporation's books.

Worthlessness

You must also show that the debt has become worthless and will remain that way. You must be able to show that you took reasonable steps to collect the debt. It is not necessary that you actually go to court to collect the debt if you can show that a judgment would remain uncollectible. If the borrower is in bankruptcy, this is a very good indication that the debt is worthless, at least in part.

Generally, the debt is considered to be worthless as of the settlement date of the bankruptcy action, but facts can show that it was worthless before this time. If you use a collection agency to attempt collection of outstanding accounts receivable or other amounts owed to you and you agree to pay the agency a percentage of what is collected, you can immediately deduct that percentage of the outstanding amount as a bad debt; your agreement establishes that that percentage will never be collected by you.

Example
You have an open accounts receivable of $1,000. After 120 days you turn it over to a collection agency that charges 30% of what it collects. At the point of your agreement with the agency you are certain you will never recoup at least $300 of the outstanding amount (the fee that would be paid to the agency if it collects 100% of the debt) and can now deduct that amount.
You may, in fact, deduct more if the agency collects less than the full amount of the debt. For example, if it collects $500 of the $1,000 outstanding, it is entitled to a $150 fee, so you recoup only $350 of the $1,000. Result: You deduct a total of $650 ($300 of which you deducted when the agreement with the agency was made).

Whether a loan is fully or only partially worthless affects whether you can claim a deduction for the loss. Business bad debts are deductible whether they are fully or partially worthless. If the loss is a nonbusiness bad debt, it is deductible only if the debt is fully worthless. No partial deduction is allowed for nonbusiness bad debts. The distinction between business and nonbusiness bad debts is explained later in this chapter.

Loss

You must show that you sustained a loss because of the debt. A loss results when an amount has been included in income but the income is never received. This might happen, for example, where an accrual method taxpayer accrues income but later fails to collect it. If you sell goods on credit and fail to receive payment, you sustain an economic loss whether you are on the accrual method or the cash method of accounting.

If you are on the cash basis and extend services but fail to collect, you cannot claim a bad debt deduction. You are not considered to have an economic loss even though you might argue that you put in your time and effort and were not justly compensated.

Example
A cash basis accountant prepares an individual's tax return. The bill comes to $400. The accountant never receives payment. She cannot deduct the $400. The accountant never reported the $400 as income, so she is not considered to have suffered an economic loss, even though she extended services and invested her time and energy.

If you make payments to a supplier for future shipments and the supplier fails to deliver because of insolvency, you have a business bad debt, regardless of your method of accounting. Again, you have an economic loss (the money you advanced to the supplier) that gives rise to the bad debt deduction.

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