5.34 Four Rules To Prove a Bad Debt Deduction

To determine whether you have a bad debt deduction in 2012, read the four rules explained below. Pay close attention to the fourth rule, which requires proof that the debt became worthless in the year the deduction is claimed. Your belief that your debt is bad, or the mere refusal of the debtor to pay, is not sufficient evidence. There must be an event, such as the debtor’s bankruptcy, to fix the debt as worthless.

Planning Reminder

Debt Worthless Before Due

You do not have to wait until the debt is due in order to deduct a bad debt. Claim the deduction for the year that you can prove worthlessness occurred.

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Rule 1. You must have a valid debt.

You have no loss if your right to repayment is not fixed or depends upon some event that may not happen. Thus, advances to a corporation already insolvent are not valid debts. Nor are advances that are to be repaid only if the corporation has a profit. Voluntary payment of another’s debt is also nondeductible. If usurious interest was charged on a worthless debt, and under state law the debt was void or voidable, the debt is not deductible as a bad debt. However, where the lender was in the business of lending money, a court allowed him to deduct the unpaid amounts as business losses.

If advances are made to a company that has lost outside borrowing sources and is thinly capitalized, with heavy debt-to-equity ratio, this indicates that the advances are actually capital contributions and not loans.

Rule 2. A debtor-creditor relationship must exist at the time the debt arose.

You have a loss if there was a promise to repay at the time the debt was created and you had the right to enforce it. If the advance was a gift and you did not expect to be repaid, you may not take a deduction.

Rule 3. The funds providing the loan or credit were previously reported as income or part of your capital.

If you are on the cash basis, you may not deduct unpaid salary, rent, or fees. On the cash basis, you do not include these items in income until you are paid.

Rule 4. You must show that the debt became worthless during 2012.

To prove the debt became worthless in 2012, you must show:

First, that the debt had some value at the end of the previous year (2011), and that there was a reasonable hope and expectation of recovering something on the debt. Your personal belief unsupported by other facts is not enough.

Second, that an identifiable event occurred in 2012—such as a bankruptcy proceeding—that caused you to conclude the debt was worthless. In the case of a business debt that has become partially worthless, you need evidence that the debt has declined in value. Additionally, reasonable collection steps must have been undertaken. That you cancel a debt does not make it worthless. You must still show that the debt was worthless when you cancelled it. You do not have to go to court to try to collect the debt if you can show that a court judgment would be uncollectible.

Third, that there is no reasonable hope the debt may have some value in a later year. You are not required to prove that there is no possibility of ever receiving some payment on your debt.

Effect of statute of limitations.

A debt is not deductible merely because a statute of limitations has run against the debt. Although the debtor has a legal defense against your demand for payment, he or she may still recognize the obligation to pay. A debt is deductible only in the year it becomes worthless. What if your debtor recognized his or her moral obligation to pay in spite of the expiration of the statute of limitations, but dies before paying? Your claim would be defeated if the executor raises the statute of limitations. You have a bad debt deduction in the year you made the claim against the estate.