It is an unfortunate reality that sometimes you loan money expecting it to be paid back over time — presumably with interest — and you are not repaid, resulting in a bad debt. Those facing bad debt may not be aware the uncollectible amount of a bona fide loan may be deductible on their taxes. However, specific criteria related to the loan must be met in order to claim a deduction. Section 166(a)(1) of the Internal Revenue Code allows taxpayers to write off a debt that becomes worthless during the taxable year. To do so, the first step is to determine whether it is a business or nonbusiness bad debt. While similar in nature, there are important differences between business and nonbusiness bad debt deductions.
Deductible business bad debts
A deductible business bad debt is the loss from the worthlessness of a debt that was either created or acquired in the taxpayer’s trade or business, closely related to the taxpayer’s trade or business when it became worthless, or is held by a C corporation. The primary motive for incurring the debt must be business related — a bad debt is not a business bad debt solely because a taxpayer runs a trade or business. These debts are generally treated as ordinary losses, which are fully deductible. Business debts that go partially bad can also be claimed.
Business bad debts can arise from loans to clients, suppliers, distributors, and employees; credit sales of goods or services; and business loan guarantees. A business bad debt may be claimed by any taxpayer including Individuals, Partnerships, C Corporations, S Corporations, Estates, and Trusts.
Even if the taxpayer liquidates or sells the business, unpaid debts are still considered business bad debts so long as the taxpayer retains the debt.
Deductible nonbusiness bad debts
Unlike business bad debts, nonbusiness bad debts are considered short-term capital losses and are therefore subject to limitations. These debts do not originate from your business. The key here is these debts must be totally worthless to be deductible — you cannot deduct a partially worthless nonbusiness bad debt. For the debt to become worthless, there must be no reasonable expectation that the debt will be repaid. You do not have to wait until a debt is due to determine it is worthless.
How to deduct a bad debt
To write off a bad debt on your taxes, you must be able to prove that the debt is worthless, and that you have taken reasonable steps to try and collect the debt, to no avail. Typically, there is an identifiable event such as the debtor’s bankruptcy, insolvency, financial difficulties, or termination that explains why the debt cannot be collected.
Furthermore, you can only take the deduction in the year the debt becomes worthless, and you must have previously included the debt amount in your income or lent cash. Deductible bad debt does not typically include unpaid rents, salaries, or fees.
For business bad debts, deduct the amount using Schedule C (Form 1040) or as an ordinary deduction on the applicable business income tax return.
For nonbusiness bad debts, you will need to provide more details to properly report on your taxes. Report a nonbusiness bad debt as a short-term capital loss on Form 8949, Sales and Other Dispositions of Capital Assets. The IRS requires a separate, detailed statement attached to your return with a description of the debt, including the amount and date it became due, the name of the debtor, any business or family relationship between you and the debtor, the efforts you made to collect the debt, and why you decided the debt was worthless.
It’s also important to note that while transfers between family members, between shareholders and their corporations, or between affiliated corporations may create bona fide debts that are eligible for the bad debt deduction, the IRS closely scrutinizes these transactions. You must show you intended to make a loan and not a gift. For example, you loaned money to a relative or a friend knowing they may not repay it. That is considered a gift — not a loan — and you cannot deduct it as a bad debt.
Proving the worthlessness of a debt is a complex topic. Partnering with experienced accounting and financial advisors can help business owners determine if their debt is worthless and ensure the necessary forms are completed to appropriately take a bad debt deduction.
Mike Kelley is a senior tax manager at RDG+Partners, a Rochester-based firm that offers tax, business planning, accounting, auditing, payroll, and wealth management services. For more information, visit www.rdgandpartners.com.l