In an ideal world, your customers would always promptly pay the money they owe for the products they purchase from you or the services you provide. Unfortunately, the world is far from ideal, especially in our current uncertain economic environment. These days, many of your customers may be taking longer to pay, and you might be concerned that some won’t pay you at all.
When customers cannot pay their obligations, you may be able to deduct these receivables as bad debts under Internal Revenue Code (IRC) Section 166. It’s important to understand what counts as partially or wholly worthless bad debt and how you can claim the Sec. 166 deduction.
Types of Business Bad Debt
A business bad debt is a loss from the worthlessness of a debt that was created or acquired in your trade or business. A debt is defined as one which arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a determinable sum of money. The most common bad debts involve credit sales to customers for goods or services. Other examples include:
- Loans to customers or suppliers that are made for business reasons and have become uncollectible;
- Business-related guarantees of debts that have become worthless; and
- Debts attributable to an insolvent partner.
The IRS will scrutinize loans to be sure they are legitimate. For example, it might deny a bad debt deduction if it determines that a loan to a corporation was actually a contribution to capital or a loan to an individual was actually a gift.
There is no standard test or formula for determining whether a debt is a bad debt; it depends on the facts and circumstances of each case. To qualify for the deduction, you must show that you have taken reasonable steps to collect the debt, and after exhausting all these reasonable efforts there is minimal likelihood it will be collected. An adequate documentation trail is a key component in supporting the deduction.
Your Accounting Method Counts
For a debt to qualify for a bad debt deduction, you must have “basis” in the debt. In other words, the debt must arise from funds you parted with, not just something you expected to receive, or the amount must have previously been included in your gross income. If, like most manufacturers, your business uses the accrual method of accounting for tax purposes, you report income as you earn it. So you can take a bad debt deduction if you previously included the entire uncollectible amount in your gross income.
If your business uses the cash method, you do not report income until you receive payment. So you cannot claim a bad debt deduction simply because someone failed to pay a bill. But you may be able to claim a bad debt deduction if you have made a business-related loan that has become uncollectible.
Wholly vs. Partially Worthless Debt
The IRC doesn’t define “worthlessness.” Courts, however, have defined “wholly worthless debts” as “lacking potential value as well as current liquid value.” The U.S. Tax Court says that partial worthlessness is evidenced by “some event or some change in the financial condition of the debtor . . . which adversely affects the debtor’s ability to make repayment.”
In general, a partially worthless status means a quantifiable portion of the debt may be recovered in the future. Lenders never recover any part of a wholly worthless debt.
Claiming the Deduction
You can write off the amount of a worthless debt on your tax return in the year it becomes worthless. For example, let’s say John owned a magnet manufacturing company which loaned $20,000 under an unsecured promissory note to an engine manufacturer—one of its biggest clients. The engine manufacturer planned to use this money for an expansion, meaning more sales for John’s company, but the manufacturer went bankrupt before it could expand and its bank perfected its lien and would be receiving all proceeds from the bankruptcy liquidation. The $20,000 loan became an uncollectible debt in 2012 because of the engine manufacturer’s insolvency. John’s company should deduct the unpaid amount as a bad debt in the company’s 2012 tax return.
If the debt is partially worthless, you can deduct up to the amount you charge off on your books during the year or you can wait until the debt becomes totally worthless. Bear in mind that there are IRS guidelines for a partial bad debt write-off to consider.
Though business bad debt can sting, understanding your options can help you work around bad debts and make the most of an unfortunate situation. If you are unsure whether you qualify for the Sec. 166 deduction, contact us for more information.
Sidebar: 3 Tips For Improving Collections
What’s better than taking the bad debt deduction? Keeping bad debts to a minimum! Here are three tips for improving collections:
- Create Expectations
Let your customers know when you expect to be paid. Include payment terms in every sales agreement you make, regardless of whether the order is from a new customer or one you have been supplying for years.
- Follow Up
Generate an accounts receivable report and review it at least monthly. After 30 days, have accounts receivable employees begin regular telephone calls to customers who haven’t paid. If follow-up calls have not worked after 60 days, have a manager speak to your contact’s supervisor or, if warranted, the company president.
- Get Tough
If a customer still does not pay and the outstanding balance is a large sum, it may be time to seek outside assistance from an attorney or collection agency. Even if the debt is settled, consider whether the customer is even worth keeping. Customers who do not pay are no better than companies that do not order.