You're in business to make money. That's hard to do when you're not paid by your customers for goods or services you've sold them. It may not be a total loss, though. You may be able to take a deduction for business bad debts. However, not just any business debt is deductible. Generally, you can take this deduction only if you can show:
- the debt is a bona fide debt owed to you
- you have a basis in the debt
- the debt arose from your trade or business, and
- the debt became entirely or partially worthless.
Bona Fide Debt
You can only deduct a bona fide (Latin for genuine or real) debt. A bona fide debt is one that's based on a valid and legally enforceable obligation to pay you money. In other words, you have to show you provided a customer or client with goods, services, or money and you expected to be paid or repaid. You are owed a bona fide debt, for example, if you sell goods or merchandise to a customer on credit. A bona fide debt also exists if there is written evidence to support it—for example, a signed promissory note or other writing stating the amount of the debt, when it is due, and the interest rate (if any). An oral promise to pay may also be legally enforceable but would be looked upon with suspicion by the IRS.
Basis in the Debt
You must have a basis in the debt to take a bad debt deduction. You have a basis in a debt only when the amount owed to you was already included in your business's gross income for the year. In other words, if you didn't treat the money owed to you as paid (and, therefore, taxable for that tax year), you can't claim a bad debt deduction. The accounting method you use for your business is critical in making this determination. There are two main methods:
- Cash method: With this method, income isn't counted until you actually receive payment
- Accrual method: When this method is used, income is counted as soon as a customer or client places an order or when you deliver goods or services; it doesn't matter when you're actually paid.
Example: You deliver 100 widgets to your customer in December 2016, but the customer pays you in January 2017. Under the cash method of accounting, you count the payment as income in January 2017. Under the accrual method, you count the order as income in December 2016. Under the cash method, you can't take a bad debt deduction in 2017 because the money isn't included in your gross income in that year. If you use the accrual method, however, you can take a deduction for any part of the debt that goes unpaid, so long as the entire amount owed was included in your December 2016 accounting books.
Almost all larger businesses use the accrual accounting method. Businesses that produce, purchase, or sell merchandise and are required to maintain an inventory must use the accrual method if they gross more than $1 million per year.
Small businesses that primarily provide services and self-employed individuals typically use the simpler cash method. As a rule, it is not possible for these businesses to deduct bad business debts because they lack a basis in their debts. Because they are cash basis taxpayers, they only report income when they are paid by their clients or customers, not when they make a sale. As a result, they don't have an economic loss (in the eyes of the IRS) when a client or customer fails to pay them.
Example: You perform 50 hours of consulting services for a client and bill the client $2,500. The client never pays. You are a cash basis taxpayer, so you don't report the $2,500 as income, because you never received it. As far as the IRS is concerned, you have no basis in the debt and cannot deduct the $2,500 as a business bad debt.
However, whether you are a cash or accrual basis taxpayer, cash loans you make for a business purpose, such as loans to a suppliers or customers, are deductible as bad debts in the year they become worthless. Business loan guarantees may also result in bad debt deduction for cash basis taxpayers.
Trade or Business
You have to show the debt arose from or was closely related to your trade or business. Your primary motive for incurring the debt must have been business related. Debts taken on for personal or investment purposes are not business debts.
Usually, it's not hard to establish the business connection. If a customer orders goods or services and you fill the order, nonpayment by the customer will result in a debt related to your business. However, you usually can forget about deducting money you lend to relatives and friends that they never pay back. The IRS will almost always consider these loans to be nondeductible gifts unless you have ironclad documentation proving otherwise.
A debt must be wholly or partly worthless to be deductible. A debt is worthless when you no longer have any chance of being repaid. You don't have to wait until the total debt actually becomes due, and you don't have to sue the customer or client in court. However, you do have to show that you took reasonable steps to try to collect the debt or that collection efforts would have been futile. For example:
- you made repeated unsuccessful collection efforts
- the debtor filed for bankruptcy or has already been through bankruptcy and had all or part of the debt discharged (forgiven) by the bankruptcy court, or
- the debtor has gone out of business, gone broke, died, or disappeared.
Keep all documentation that shows a debt is worthless, such as copies of unpaid invoices, collection letters you’ve sent the debtor, logs of collection calls you’ve made, bankruptcy notices, and credit reports.
You must deduct the entire amount of a bad debt in the year it becomes totally worthless. If only part of a business debt becomes worthless—for example, you received a partial payment before the debt became uncollectible—you can deduct the unpaid portion that year, or you can wait until the following year to deduct it. For example, if you think you might get paid more the next year, you can wait and see what your final bad debt amount is before you deduct it.
Claiming the Deduction
Generally, business bad debts are reported as ordinary losses on Form 1040 using Schedule C, Schedule F or Schedule A. If you didn't take a deduction on your original return for the year it became worthless, you can file a claim for a credit or refund. If the bad debt was totally worthless, you must file a claim by the later of:
- seven years from the date your original return was due, excluding any filing extensions, or
- two years from the date you paid the tax.
If the debt is partially worthless, you must file a claim by the later of:
- three years from the date you filed your original return, or
- two years from the date you paid the tax.
Depending on your type of business, you claim a refund or credit by filing:
- Form 1040X if you're a sole proprietor, owner of a one-person limited liability company, or farmer
- Form 1120X if your business is a regular C corporation, and Form 1120S if it's an S-Corporation, or
- Form 1065 if you're in a partnership or a multi-owner limited liability company.
If You Collect a Bad Debt
If you claim a deduction for a bad debt on your income tax return and later collect all or part of it, you’ll have to include all or part of the amount you receive as income in your tax return for the year. The amount you include is limited to the amount you actually deducted for the bad debt. However, you can exclude the amount deducted that did not reduce your tax. You report the amount as “Other income” on the appropriate tax form.
Questions for Your Attorney
- Is it better to deduct a partially worthless business bad debt, or should I wait until the debt is totally worthless?
- My copartner left our partnership and he can't pay his share of the partnership debts. If I'm forced to pay his share, can I take a business bad debt deduction?
- My business has valid business bad debts in the amount of $25,000. A collection agency offered to buy the debts for $15,000. If I sell the debts, can I still take a deduction? If so, how much? Can I take it on my return for the year?