Every business owner faces collection challenges at some point in their businesses. Whether the amounts are large or small, when you’re trying to grow your business, every dollar counts. Likewise, every dollar you don’t get paid means either hours of hunting down the payment, writing it off as bad debt, or both.
To qualify as a bad debt in the eyes of the IRS, the debt must either have been created or acquired in your business, or closely related to your trade or business when it became partly or totally worthless.
Examples of bad debts include:
- Loans to clients and suppliers. Sometimes, a supplier or client will ask to get your services on credit or may need some money fronted to complete a deal. If you lend money to a client, supplier, employee or distributor for a business reason and you can’t collect, you can consider the amount a bad debt.
- Goods sold and/or services rendered, but not yet paid for. If the goods or services have been recorded in your accounts receivable and you have tried to collect the amount due, the amount becomes a business bad debt.
- Debts of an insolvent partner. If your business partnership breaks up and one of your former partners turns out to be insolvent, you can claim the portion you have to pay of your partners’ share as a bad debt.
- Debts of a client you put up a guarantee for. If you paid a portion of a debt to help a client and the client defaults on the loan, you can claim the bad debt only for the amount you paid.
- Sale of mortgaged property. If your mortgaged property is sold for less than the debt, the unpaid balance of the debt is bad debt.
Remember, you can claim a business bad debt deduction only if the amount owed to you was included in your business’s gross income or lent out of your cash. If you use an accrual method of accounting, you generally report income as you earn it. If you use the cash method of accounting, you generally report income when you receive payment. With the cash method, you generally cannot claim a bad debt deduction for unpaid wages, rents, fees, and similar items because you never included those amounts in income.
How long do you have to wait before knowing the debt is a bad one?
You must be able to prove the debt is worthless by showing you have taken reasonable steps to collect the debt. Keep records of every correspondence and collection attempt, and make sure the debt is recorded in your business’s accounting system. If the debtor has entered into bankruptcy, make sure you keep documentation from the bankruptcy court.
Generally, you must claim a business bad debt in the same year the debt became worthless. If you have some partially worthless debts, you can use the Specific Charge-Off Method, which allows you to claim parts of the debt over several tax years if the debt’s worthlessness is drawn out. There is also the Nonaccrual-Experience Method, for accounts receivable for services you performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, performing arts; or if your business meets the $5 million gross receipts test. For more on these methods, see the IRS website.
If you mistakenly forgot to deduct a bad debt on your tax return in the year it became worthless, you can file a claim for a credit or refund.
If the bad debt was worthless, you must file the claim by the latter of the following dates:
- 7 years from the date of your original return; or
- 2 years from the date you paid the tax.
If the claim is for a partially worthless bad debt, you must file the claim by the latter of the following dates:
- 3 years from the date you filed your original return; or
- 2 years from the date you paid the tax.
You have longer to file the claim if you were unable to file your taxes and submit the claim due to a physical or mental impairment.
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