Abstract: When customers can’t pay up, it may be possible to deduct these bad debts under Internal Revenue Code (IRC) Section 166. But it’s important to understand what counts as partially or wholly worthless bad debt and how to claim the deduction. This article describes the different types of business bad debt and how the accounting method affects how it’s reported. But it’s better to avoid bad debt to begin with, so a sidebar offers three tips to improve collections.
The Sec. 166 deduction
What you need to know about business bad debts
In an ideal world, your customers would always promptly pay the money they owe for the products they buy from you. Unfortunately, the world is far from ideal. 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.
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’ve 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 haven’t 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 doesn’t 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 don’t pay are no better than companies that don’t order.
Fortunately, when customers can’t pay up you may be able to deduct these bad debts under Internal Revenue Code (IRC) Section 166. As you work with your tax advisor to prepare your 2014 tax returns, 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, or was closely related to your trade or business when it became partly or totally worthless. 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’re 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.
There’s 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 simply must show that you’ve taken reasonable steps to collect the debt and there’s little likelihood it will be paid.
Your accounting method counts
For a debt to qualify for a bad debt deduction, you must have previously included the amount 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 don’t report income until you receive payment. So you can’t 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’ve 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, the lender recovers a portion of a partially worthless debt 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. He lent $20,000 to an engine manufacturer — one of his biggest clients. The engine manufacturer planned to use this money for an expansion, meaning more sales for John, but the company went bankrupt before it could expand. The $20,000 loan became an uncollectible debt in 2014 because of the engine manufacturer’s insolvency. John can deduct the unpaid amount as bad debt in his company’s 2014 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.
Making the most of a bad situation
Though business bad debt can sting, understanding your options can help you work around bad debts. If you’re unsure whether you qualify for the Sec. 166 deduction, contact your tax advisor for more information.