Business or nonbusiness debt?

The first step is to determine whether a debt is a business or nonbusiness debt. This is important because business bad debts generate ordinary losses, while nonbusiness bad debts are reported as short-term capital losses. The latter can be used only to offset capital gains (plus up to $3,000 in ordinary income). Also, unlike with business bad debts, you can’t take a deduction for partially worthless nonbusiness bad debts. They must be totally worthless to be deductible.

A business bad debt is a loss related to a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly or totally worthless. Common examples include credit sales to customers for goods or services, loans to customers or suppliers, business-related guarantees, and loans by those in the business of lending money.

Some debts are considered both business and nonbusiness (personal). For example, say you guarantee a loan on behalf of one of your best customers, who also happens to be a close personal friend. If your friend later defaults on the loan, the test for whether your loss is business or nonbusiness is whether your “dominant motivation” in making the guarantee was to help your business or to help your friend.

If a bad debt is related to a loan you made to your business, the IRS may deny a bad debt deduction if it finds that the loan was actually a contribution to capital.

Is it bona fide?

To qualify for a bad debt deduction, the underlying debt must be bona fide. That is, you must have loaned the money or extended credit with the expectation that you would be repaid and with the intent to enforce collection if you weren’t repaid. A written note or loan agreement can help establish your intent, although formal documentation isn’t required if you have other evidence that shows the transaction was a legitimate loan and not a gift.

Did you include it in income?

Not all bad debts give rise to deductions. The purpose of the deduction is to offset a previous tax liability. That means you must have previously included the receivable in your income. Typically, that’s not the case with respect to accounts receivable if your business uses the cash-basis method of accounting. Cash-basis taxpayers generally don’t report income until they receive payment. If someone fails to pay a bill, the business simply doesn’t include that amount in income. Permitting a bad debt deduction on top of that would give the business a windfall from a tax perspective.

Accrual-basis taxpayers, on the other hand, report income as they earn it, even if it’s paid later. So, a bad debt deduction may be appropriate to offset uncollectible amounts previously included in income.

Totally or partially worthless?

You can deduct the portion of a debt that has become partially worthless, but only if that amount has been “charged off” for accounting purposes during the tax year. The IRS takes the position that simply recording an allowance or reserve for anticipated losses isn’t enough. You must treat the amount as a sustained loss, which requires specific language in your business’s books.

Deductions for totally worthless debts don’t require a charge-off. But it’s a good idea to do so anyway. Why? Because if the IRS determines that the debt was only partially worthless, it can disallow the deduction absent a charge-off.

Keep in mind that a totally worthless debt must be deducted in the year it becomes totally worthless (which may be before it comes due). If you miss a deduction that should have been taken in an earlier year, you can claim the deduction by filing an amended return. But that’s only if the statute of limitations for amended returns hasn’t expired. If the proper year for deducting a bad debt is unclear, consider claiming the deduction as early as possible to ensure it isn’t lost. You can always amend your return if future developments indicate that the deduction should be taken in a later year.

Review your debts

As you work to file your tax return, review your business debts to assess whether any became partially or totally worthless during 2017. If so, be prepared to document your efforts to collect the debt and provide other proof of worthlessness. (See “Proving worthlessness.”)

Sidebar: Proving worthlessness

A debt is worthless when the surrounding facts and circumstances indicate there’s no reasonable expectation of payment. Facts that may support this conclusion include the debtor’s bankruptcy or insolvency, a sharp decline in the value of any collateral or, in the case of an individual debtor, the debtor’s death or disappearance.

Often, the best evidence of worthlessness is showing that you’ve taken reasonable steps to collect the debt. That doesn’t necessarily mean going to court if you can prove that a judgment would be uncollectible.

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