The IRS allows taxpayers to minimize their income tax via bad debt deduction. Here’s how it works.
4 Steps to Receiving Bad Debt Deduction
Bad Debt Definition: Uncollectible account from clients, customers, employers, or other debtors
Step 1: Know What the IRS Considers as Bad Debt
There are instances when customers or debtors simply refuse to pay, despite relentless collection efforts. This kind of financial dispute can be taken to a small claims court, but even then there’s never a guarantee of a favorable result.
When worse comes to worst, there’s a way to soften the financial blow of uncollectible accounts. That is via tax write-off, specifically bad debt deduction.
As for the IRS, bad debt may result from the following general categories:
- Personal loans
- Business loans
- Credit sales
Step 2: Know the Difference Between Nonbusiness and Business Bad Debts
Bad debts come in two kinds. These include nonbusiness and business bad debt.
Nonbusiness bad debts are financial transactions made outside any trade or business enterprise. A basic example of this kind of debt is personal loans provided to friends and family members, as an act of goodwill.
For instance: a debtor may have loaned out cash to a coworker who had since transferred to a different state and can no longer be reached by any mode of communication. Or, in other cases, someone may have given a loan to individuals who had recently filed for bankruptcy.
The IRS deducts nonbusiness bad debts from a tax return only if the debts have been rendered completely worthless. Complete worthlessness is established by proving expecting that debt to be repaid even in partially has become unreasonable.
Nonbusiness debt that has been partially paid does not qualify for bad debt deduction. This means that a personal loan amounting to a $1,000, and which has already been paid in half, no longer qualifies for a tax write-off.
Here the operative word is complete worthlessness, which means no collection has been made or can be made, at any amount, whether partial or full.
Nonbusiness bad debts become eligible for a tax deduction as soon as they are deemed worthless. Creditors need not wait for the agreed payment date to declare a debt worthless.
Also, it is important to have ample evidence with regards to the legitimacy of a nonbusiness bad debt. Otherwise, the IRS might consider it a personal gift, which does not qualify for a tax write-off.
To avoid the latter scenario, make sure to keep copies of letter and invoices, or even transcripts of phone calls, that convey debt collection efforts made over time.
Meanwhile, business bad debts result from either a direct trade or business transaction, or a transaction closely linked to an existing trade or business. Here, a transaction is considered closely linked to an existing trade or business if its main motivation is business-related, i.e., loans made to business partners and stakeholders.
Business bad debts include the following:
- Loans to clients, employers, suppliers, and distributors
- Business loan guarantees
- Credit sales to customers
Unlike nonbusiness debts, business debts can be labeled as bad in both cases where they have been rendered partially or completely worthless. This means that the outstanding balance of debts that have been partially paid can still be included as a tax write-off.
The Accrual Accounting Method
There are limitations to tax write-offs resulting from business bad debts. For one thing, a business must have employed the accrual accounting method throughout its operations.
This method records sales at the same time a customer is billed. That is unlike the cash accounting method which records sales only upon actual receipt of payment.
The accrual accounting method allows businesses to pull out uncollectible accounts from the sales sheet and record them as bad debt instead.
Step 3. Report the Loss to the IRS
For nonbusiness bad debts, the reporting process is pretty straightforward. The IRS Form 8949 (Sales and Other Disposition of Capital Assets) must be accomplished and submitted.
Debt amount goes to part 1’s line 1 while the name of debtor goes to column (a). Bad-debt statement is also usually requested from taxpayers.
This statement explains the nature of the loan provided and the circumstances surrounding its nonpayment. Remember that nonbusiness bad debts must be declared on the same year it’s been rendered worthless.
For missed declarations, the IRS allows three years from the year debt has been deemed worthless for a taxpayer to claim a tax write-off.
Meanwhile, for businesses declaring business bad debt, here are the IRS forms that must be accomplished:
- Self-employed (Schedule C, Profit or Loss from Business (Sole Proprietorship)
- Partnerships (Line 12 of Form 1065, U.S. Return of Partnership Income)
- Corporations (Line 15 of Form 1120, U.S. Corporation Income Tax Return)
- S Corporations (Line 10 of Form 1120S, U.S. Corporation Income Tax Return for an S Corporation)
Accounts Receivable Aging Report
On top of the abovementioned forms, businesses must also prepare an Accounts Receivable Aging Report. This document shows all collectible accounts and their corresponding payment schedules.
This report helps the IRS ascertain whether a collectible account has indeed turned into a business bad debt.
Step 4. Declare Accrued Bad Debt on Your Tax Return
Bad debts must be accurately declared on tax returns. Deductions should be made from IRS-recognized items from a taxpayer’s income and capital sheet.
This is the normal write-off schedule followed by the IRS for nonbusiness bad debts:
- Short-term gains
- Long-term gains
- Other income
This means that bad debt is first deducted from short-term gains, then long-term gains, and so on. These tax return items allow for specific limited amounts for write-offs.
Often, bad debts of large values have to wait for a couple of years before they are completely written off.
Meanwhile, business entities declaring bad debt have to choose from any of these write-off methods:
- Direct write-off
- Allowance method
Bad debts should not result in a total waste of asset or capital. Via bad debt deduction, business and nonbusiness entities are given the chance to offset financial losses due to uncollectible accounts.
Do you have any experience with bad debt deduction? Share them in the comments section below.
If you owe back taxes, visit taxreliefcenter.org for more information on tax relief options.