If debt collection is a problem for your business, deducting uncollectible (bad) debts from your tax bill may somewhat lessen the sting of simply writing the debt off your books. Here is some basic information on deducting business bad debts.
First, the debt must be legitimate. A bona fide debt arises from a debtor-creditor relationship and is based on a valid and enforceable obligation to pay a fixed or determinable amount of money. For debt creation, the business must be able to show that it was the intent of the parties at the time of the transfer to create a debtor-creditor relationship. In other words, the business must be able to show that, at the time of the transaction, there was a real expectation of repayment, and there was intent to enforce the indebtedness.
While a formal loan agreement is not absolutely necessary to create a bona fide debt, it is a good practice to use written debt agreements. However, giving a note or other evidence of legally enforceable indebtedness is not by itself conclusive evidence of a bona fide debt. For example, if the terms of the note are routinely ignored or penalties for skipped or late payments are not enforced, the IRS could successfully argue that there was not a real debt.
For most businesses, it is common to encounter uncollectible or worthless debts. Two types of bad debt deductions are allowed by the IRS: business bad debts and nonbusiness bad debts. Business bad debts give rise to ordinary losses that can generally offset taxable income on a dollar-for-dollar basis. Nonbusiness (personal) bad debts are considered to be short-term capital losses. Because there is a limitation on deducting capital losses, distinguishing business and nonbusiness bad debts is critical.
Business bad debts generally originate as credit sales to customers for goods delivered or services provided. If a business sells goods or services on credit and the account receivable subsequently becomes worthless, a business bad debt deduction is permitted, but only if the revenue arising from the receivable was previously included in income.
Business bad debts can also take the form of loans to suppliers, clients, employees, and distributors. Additionally, a business bad debt deduction is allowed for any payments made in the capacity as guarantor if the reason for guaranteeing the debt was business related. Here, the guarantor’s payment results in a loan to the debtor, and the taxpayer is generally allowed a bad debt deduction once the loan becomes partially or totally worthless.
Worthlessness can be established when the business sues the debtor, and then shows the judgment is uncollectible. However, when the surrounding circumstances indicate a debt is worthless and uncollectible, and that legal action to collect the debt would in all probability not result in collection, proof of these facts is generally sufficient to justify the deduction.