Credit enables many customer transactions that would not otherwise be possible. If your business offers customer credit, you’ve most likely had someone unable to repay their debt. If you report these sales as income but cannot collect, the IRS calls this “business bad debt.” In these cases, the IRS allows you to deduct those debts to decrease your federal tax liability. These frequently asked questions will help you understand how to proceed if this happens to your business.

When is a business debt considered “bad”?

There are two kinds of bad debts — business and personal.  Business “bad debt” is a loss from an uncollectible loan. These loans can be from clients or suppliers, previous partners, or political parties.

Depending on your accounting practices, credit sales for goods or services that have not been paid in a reasonable period of time may be considered bad debt. If your business uses a cash accounting method, you only report the income once you receive it; therefore, you cannot claim a bad debt because you did not yet count the sale as income.  If your business uses accrual accounting, you may have already included the sale as income. In that case, the sales would be classified as bad debts and are subject to deductions.

Not only do some credit sales lead to bad debt, but also debts from a former business, debt acquired from a decedent, and liquidation of a business. If you retained your receivables from a previous business, but then you were unable to collect, those can be considered bad debt. This is the same if you liquidate your business and you do not collect on all of the accounts receivable. 

What does the IRS allow as business bad debt?

The IRS distinguishes several different types of business bad debts.  As of July 2010, the following types of debt may be considered bad debt, however, check IRS.gov for the most current information.

- Loans to Clients and Suppliers. When you loan money to an outside party for business purposes, you expect to be repaid in a timely fashion. If your attempts to collect on any such loan are unsuccessful, the debt becomes worthless and your business takes a loss.

- Debts to Political Parties. If a political party owes you money and attempts to collect on the money is unsuccessful, the debt becomes worthless and your business takes a loss.  Restrictions may apply, so review the guidance at IRS.gov for details.

- Debts of an Insolvent Partner. If your partnership breaks up and your former partner is unable to make payments on their debts, you can claim any part of your insolvent partner’s share of the debt as a bad debt deduction.

- Sale of a Mortgaged Property. If you business sells a property for less than the debt, the amount of the unpaid and uncollectible balance is a business bad debt.

For IRS examples and more information, please refer to Chapter 10 of IRS Publication 535.

How does my business claim bad debt?

The IRS lists two methods for claiming a bad debt:  the Specific Charge-Off Method and the Nonaccrual-Experience Method. Although the specific charge-off method is most commonly used, if you meet certain requirements, the nonaccrual-experience method is an alternative option.

- Specific Charge-Off Method This method is used if your business has specific bad debts that have become either partially or totally worthless during the tax year. You can deduct the business bad debt that you take-off your books. This includes sales that you have accounted for, but then were not able to collect. Removing it from the books changes your tax liability. Consult with your accountant before modifying your books.

- Nonaccrual-Experience Method The nonaccrual-experience method requires your losses to meet specific criteria. First, the debt must be from a professional service, such as accounting, actuarial science, architecture, consulting, engineering, health, law or performing arts. This service cannot include lending money, selling goods, or acquiring receivables. Second, your gross receipts cannot exceed $5 million for any of the 3 previous tax years.

Bad Business Debts can be deducted using either method on the 1120 IRS form line 15.

What happens if I collect on a debt after it’s been reported as bad debt?

In some cases, you may collect on a debt that has already been written-off as bad debt. These collections must be reported to the IRS. Reporting the correct amount can be tricky and the guidelines differ depending on the circumstances. Consult with your accountant before taking any action.

Remember, it’s always wise to speak with your accountant before making a claim to make sure you qualify and change the books correctly.

If you have further questions post them on the Filing and Paying Taxes discussion board in the Community.

Source - http://www.business.gov

Related Resources

· IRS Publication 535 – IRS Publication on Business Expenses. Chapter 10 provides specific details on Business Bad Debt

· IRS Topic 453 – Bad Debt Deduction – IRS information on a general overview of bad debt.