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 advance wages to your employee, you are effectively making a loan. While it's not usual to put anything in writing, what if the employee fails to work the required amount to earn the advance? In such a case, you have a bad debt.

In making advances to an employee, make sure any repayment schedule does not run afoul of minimum wage rules (check with your state labor department). Also, take employment taxes into account when the work is performed, not when the advances are made.

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.

For business bad debts, the IRS Chief Counsel has said that amounts must be charged off the company's books to show that the business has abandoned hopes of a recovery. Merely reducing a reserve account is not sufficient for this purpose.

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.

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.

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.

Business Bad Debts

Business bad debts are treated as ordinary losses that offset ordinary business income. To be treated as a business bad debt, the debt must be closely related to the activity of the business. There must have been a business reason for entering into the debtor-creditor relationship.

Business bad debts typically arise from credit sales to customers. They can also be the result of loans to suppliers, customers, employees, or distributors. Credit sales are generally reported on the books of the business as accounts receivable. Loans to suppliers, customers, employees, or distributors generally are reported on the books of the business as notes receivable. When accounts receivable or notes receivable become uncollectible, this results in a business bad debt.

Valuing a Bad Debt

Accounts receivable and notes receivable generally are carried on the books at fair market value (FMV). Thus, when they go bad, they are deductible at FMV. This is so even where that value is less than the face value of the obligations.

Impact of Loans with Your Business or Associates

If you lend money to your corporation and the corporation later defaults, you cannot claim a bad debt deduction unless it was a true loan. If, as explained earlier, the advance to the corporation was in fact a contribution to its capital, then you cannot claim a bad debt deduction.

If you have a partnership that breaks up and there is money owing from the partnership, you may be forced to make payments if your partner or partners do not. This payment may be more than your share of the partnership's debts. In this case, you can claim a bad debt deduction if your partner or partners were insolvent and you were required to pay their share.

If you go out of business but still try to collect outstanding amounts owed to you, potential bad debt deductions are not lost. You can still claim them as business bad debts if the debts become worthless after you go out of business.

Nonbusiness Bad Debts

Loans made to protect investments or for personal reasons give rise to nonbusiness bad debts when they go bad.

When to Claim the Deduction

In general, a bad debt deduction in the case of a guarantee is claimed for the year in which payment is made by the guarantor. Suppose you guarantee a debt but have the right of subrogation or other right against the debtor to recoup your outlays. In this case, you claim your bad debt deduction only when the right against the debtor becomes worthless.

Nonaccrual-Experience Method

Taxpayers on the accrual basis have an alternative way to account for bad debts. Income that is not expected to be collected need not be accrued. If, based on prior experience, it is determined that certain receivables will not be collected, then they need not be included in gross income for the year. Since income is not taken into account, there is no need to then claim a bad debt deduction.

The nonaccrual-experience method applies only to accounts receivable for performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. In addition, the business's average annual gross receipts for the 3 prior years cannot be more than $5 million. It cannot be used for amounts owed from activities such as lending money, selling goods, or acquiring receivables or the right to receive payments. Nor can this method be used if interest or penalties are charged on late payments. However, merely offering a discount for early payment is not treated as charging interest or a late penalty if the full amount is accrued as gross income at the time the services are provided and the discount for early payment is treated as an adjustment to gross income in the year of payment.

This method can be used under either a separate receivable system or a periodic system. The separate receivable system applies the nonaccrual-experience method separately to each account receivable; the periodic system applies it to the total of the qualified accounts receivable at the end of the year. This is a highly technical accounting rule that should be discussed with an experienced accountant. The nonaccrual-experience method is explained more fully in IRS Publication 535, Business Expenses.

Review Credit Policies

To avoid bad debts, consider whether to eliminate or modify your credit policy. For example, instead of billing customers when work is completed or goods are shipped, have customers charge the payments to a credit card that you accept.

If, because of industry policy or personal preference, you want to continue to extend credit to customers, consider:

• Doing credit checks on customers. When extending credit for B2C, check a consumer's credit through one of the 3 major credit bureaus: Equifax (www.equifax.com), Experian (www.experian.com), and Trans-Union (www.transunion.com). You need the permission of the consumer to do this. For B2B, check a business's credit at D&B (www.dnb.com) and Experian (www.experian.com/small-business/services.jsp). You do not need the permission of the business customer do to this.

• Limiting credit to customers. You do not have to extend the same terms to all customers.

• Billing wisely. Instead of billing at the completion of a job, bill at completion points along the way. Bill promptly (don't wait until the end of the month to send invoices). Send bills electronically to make sure they arrive promptly.

Review Collections Policies

The longer an account receivable goes unpaid, the less likely it becomes that you will receive full, or even any, payment. Make sure to stay on top of collections by monitoring receivables on a regular basis. Contact delinquent accounts to press for collections (work out payment terms where applicable). Observe debt collection practice rules under the Fair Debt Collection Practices Act (go to www.ftc.gov for more information).

If you are having difficulty collecting what is owed to you, consider:

• Working with a collection agency. The agency receives a fee, usually equal to a percentage of what is collected; you receive the balance. You can deduct the fee you pay to the agency.

• Engaging an attorney. The attorney can seek to collect on your behalf. Determine in advance what payment the attorney will receive (hourly, a percentage of collection, etc.). You can deduct the attorney's fee.

• Taking customers to small claims court. Determine your legal rights and whether you can bring your claim to small claims court. You can deduct any court costs you pay; you cannot deduct any amount for your time and effort.

Strategies When Customers Go Bankrupt

If a customer files for bankruptcy, understand your options. Bankruptcy means you can't continue collection activities. Depending on the amount of money owed to you, you may want to file a proof of claim with the bankruptcy court (you'll get the details when you receive a bankruptcy notice) and pursue collection; expect in most cases to collect only pennies on the dollars you're owed.