Bad debts arise because money was lent to a borrower or credit was extended to a customer for the purchase of a product or service, but the recipient was unable to partially or fully repay the liability. The following required factors determine the deductibility of bad debts:
- there was a bona fide debtor-creditor relationship
- the debt was worthless, meaning that there is little chance to collect either a partial or a full amount
- there was a reasonable effort to collect the debt, and
- the taxpayer has suffered an economic loss because of the bad debt
A debtor-creditor relationship implies that the borrower has a legal obligation to repay the loan or to pay for the goods or services. Any loan agreement should stipulate at least the loan amount, interest rate, maturity date, and repayment schedule. Money given to a corporation should be evidenced as a loan with a loan agreement; otherwise, it may be treated as a nondeductible contribution of capital. A true creditor-debtor relationship must exist between the taxpayer and the borrower. If the taxpayer is related to the borrower, then the IRS may treat the loan as a gift rather than as a true loan. To claim the bad debt deduction, the transaction must have been intended as a loan and not as a gift.
Worthlessness of a debt can be established by the insolvency or bankruptcy of the debtor or by the futility of trying to collect the debt, such as suing the debtor or turning the account over to a collection agency, or by showing that other reasonable steps were taken to collect the debt. It is not necessary to sue the debtor, but the taxpayer must show that a judgment would be uncollectible. However, if the borrower is undergoing reorganization in bankruptcy, then the bad debt cannot be written off until the court approves the reorganization, since the debt may have some value, depending on the reorganization.
If a collection agency is used, then the percentage charged by the collection agency can be deducted, because the taxpayer will not receive that amount. So if a $1000 bad debt is turned over to a collection agency that charges 40%, then $400 can be deducted when the debt is turned over. The remaining amount can be deducted when it is determined that it is uncollectible. Bankruptcy is generally good evidence to indicate worthlessness for at least some of an unsecured or non-preferred debt. Note that worthless securities are not deducted as bad debts but as capital losses.
If a deduction was not claimed on a worthless debt when it became worthless, then the taxpayer has up to 7 years to file an amended return to claim the deduction.
A bad debt can only be deducted if the taxpayer suffers an economic loss and only if it has been reported as income. If the bad debt results from nonpayment because of extending credit for a product, then the debt is not deducted. The loss is simply accounted for as a cost of goods and other expenses related to producing the product. If services were provided but were not paid for, then no bad debt deduction is allowed, since only economic losses are deductible. That the taxpayer expended time and effort in providing the service or suffered an opportunity cost does not affect the disallowance of the deduction. However, expenses that were incurred in providing the service can still be deducted.
A cash basis business will generally not have a bad debt, since income is not recognized until the cash is actually received. If the income is not included in the tax return, then there is no bad debt deduction. For instance, if a landlord cannot collect rent from a tenant, then the uncollected rent cannot be deducted by a cash basis taxpayer because it will not be reported as income. If the landlord uses the accrual method, then it can be deducted as a bad debt only if the income was already reported; otherwise, the taxpayer can simply remove the uncollected rent from accrued income.
Business and Nonbusiness Bad Debts
The tax rules that apply to bad debts depend on whether it is a business or nonbusiness bad debt.
Business bad debts must be related to the business activity and there must have been a business reason for the debt. Business bad debts generally arise as credit sales to customers, which are recorded in accounts receivable, or as loans to suppliers or distributors, customers, or employees, which are recorded as a notes receivable. Uncollectible accounts receivable or notes receivable are considered business bad debts.
If a partner is required to make payments on the debts of other partners or the partnership that exceeds the partner's share of the debt, then payments for any uncollected debt can be deducted as a business bad debt by the partner. Deductions for business bad debts can also be claimed even after the business ends.
A nonbusiness bad debt is any debt that is not a business bad debt — either a personal debt or a debt related to investments. A partial loss of a business bad debt can be deducted; however, only a total loss of a nonbusiness bad debt can be deducted — there is no partial deduction allowed.
Business bad debts can be deducted as ordinary losses. Nonbusiness bad debts are deducted as short-term capital losses that can offset capital gains; if the result is a net capital loss, then it can be used to offset up to $3000 ($1500, if married, filing separately) of other income; any remaining loss can be carried forward as a short-term capital loss.
Examples of Deductible Bad Debts
Some examples of bad debts include the following:
- You deposit some money with a contractor to have a home built, but then the contractor becomes insolvent and is unable to return the deposit or build the house.
- A mechanics or suppliers lien is placed on property because the contractor failed to pay them, so you pay to have the lien removed. If you are unable to collect the amount paid from the contractor, then the amount can be claimed as a bad debt deduction.
- A homebuyer assumes the mortgage of the taxpayer, but, to satisfy the lender, the taxpayer remains liable for the repayment of the mortgage loan in case the buyer defaults. The buyer does default, so the lender sold the home, but received less than the loan amount, so you are obligated to pay the lender for the deficiency. If you cannot collect the deficiency amount from the defaulted buyer, then the amount can be deducted as a bad debt.
Loans by Shareholder-Employees to Their Corporations
If a taxpayer lends money to a corporation in which she is a shareholder, then a bad debt deduction cannot be claimed unless it was a true loan, evidenced by a legal promissory note.
If a shareholder who is also an employee lends money to the corporation, but fails to receive repayment, then whether it is treated as a business or a nonbusiness bad debt depends on the purpose of the loan. If the loan was to protect the investment, then it is treated as a nonbusiness bad debt. If the loan was made to protect the compensation that the shareholder-employee earned from working, then it is treated as a business bad debt.
Factors that are used to differentiate between the 2 cases include the investment amount, salary from the corporation, and other sources of income that are available to the taxpayer. Generally, if the investment is large compared to the salary or if the taxpayer has other major sources of income, then the loan will be treated as a nonbusiness bad debt.
For shareholder-employees, classifying the debt as a nonbusiness bad debt is preferable, since it is treated as a short-term capital loss that can be used to offset capital gains and up to $3000 of other income. Any remaining amount can be carried forward indefinitely. On the other hand, a business bad debt for the employee is not deductible. Moreover, the deduction is not allowed for alternative minimum tax purposes.
Personal Guarantees on Loans
Shareholders of a corporation do not have personal liability for the debts of the corporation. However, banks and other creditors will not extend loans to a corporation lacking an extensive credit history or assets to collateralize those loans. Therefore, the business owners are generally required to extend personal guarantees on the loan. For instance, a loan guaranteed by the Small Business Administration must be guaranteed by an owner with at least a 20% interest in the business. As with shareholder loans to corporations, whether guarantees are considered business or nonbusiness bad debt depends on the motive for guaranteeing the loan. If the main purpose was to protect the investment, then it is treated as a nonbusiness bad debt; otherwise, it is treated as a business bad debt.
Payments made on loan guarantees are deductible when paid. A bad debt deduction can be claimed by a guarantor if:
- the guarantee was a part of normal business operations and had a business purpose;
- there is a legal requirement to repay the debt; and
- the guarantee was made before the loan became worthless.
A bad debt deduction can only be claimed for a guarantee agreement that protects an investment or to make a profit. If a loan guarantee was made to friends or family without receiving any consideration for the guarantee, then the payments are considered a gift that cannot be deducted.
The guarantor can claim the bad debt deduction when the payment is made. If the guarantor has a right of subrogation – i.e., to take the place of the lender – or a right to some other means of obtaining repayment, then the bad debt deduction cannot be claimed until the right is determined to be worthless.
If there was more than 1 guarantor of the loan, but that taxpayer pays the debt because the others were unable to pay it, then the paying guarantor can deduct the entire debt as a business bad debt. Otherwise, the guarantor can only claim a loss of his own proportionate share.
If the guarantor substitutes his own note to replace the note for the business, then the bad debt deduction can only be claimed when payments are made on the note and only in the amount of the payments.
Reporting Bad Debts
When bad debts are reported by individual taxpayers — but not by business entities, such as partnerships or corporations — additional information must be provided in a separate statement:
- name of the debtor
- description of the debt
- loan due date
- family or business relationship to the debtor
- if there is a relationship, then it may not be considered a bona fide debt
- debt collection efforts
- how the worthlessness of the debt was determined
Business bad debts are reported on business tax forms, such as Schedule C, Profit or Loss from Business, but nonbusiness bad debts are reported as short-term capital losses on Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses.
If a bad debt is eventually recovered, then a business simply adds it to income in the year that is recovered. Filing an amended tax return is unnecessary.