No matter how thoroughly you check your customers’ credit or how diligently you pursue collection of accounts receivable, you can still end up with uncollected debt.
But there could be a silver lining: In certain situations, you can deduct bad debt on your federal income tax return to offset ordinary business income. This, in turn, could lower your business’ overall tax liability.
Factors to Consider
Whether bad debt is deductible depends on several factors. The first step is to determine if an uncollected receivable meets the IRS definition of business bad debt.
According to the IRS, the uncollected debt must be closely related to your trade or business, and there must be a valid debtor-creditor relationship. Such a debt qualifies as bad debt “if your primary motive for incurring the debt is business related,” states the IRS. Also, there must be a legitimate expectation of repayment and an intent by your company to enforce the debt obligation.
Specific examples of business bad debt cited by the IRS include loans to clients and suppliers that are not repaid after repeated collection attempts, credit sales to customers for goods that have been sold or services that have been rendered, and business loan guarantees.
If you have unsuccessfully attempted to collect debt over a reasonable period and there’s no longer a realistic chance that the debt will be paid, then the uncollected amount will likely qualify as business bad debt. In this scenario, deduct the bad debt from your gross business income on Form 1040 Schedule C during the taxable year when it becomes wholly worthless.
Another factor is whether your business uses accrual- or cash-basis accounting. For the bad debt to be deductible, you must have previously included the debt in your business income, which wouldn’t be the case if you use cash accounting. Therefore, you must use accrual accounting to deduct bad debt.
Recent Tax Court Cases
A recent Tax Court case helped clarify what qualifies as a bona fide business bad debt. In Yaryan v. Commissioner, TC Memo 2018-129, the Tax Court denied a business bad debt deduction because it concluded that the taxpayer wasn’t engaged in an active trade or business but instead was just a passive investor in a business.
Meanwhile, another Tax Court case helped clarify the IRS’ expectations in regard to providing proof that a debt becomes worthless during the year when you claim it does. In Sarvak v. Commissioner, TC Memo 2018-68, the Tax Court denied a business bad deduction because the taxpayer failed to present evidence that the bad debt was objectively worthless during the year he claimed it was.
These two recent Tax Court cases emphasize the seriousness the IRS places on ensuring that business bad debt deductions are legitimate, as well as the importance of substantiating the timing of your collection efforts.
Salvaging a Tax Benefit
While bad debt can be frustrating, you may be able to salvage a tax benefit out of an otherwise unfavorable situation. Talk to a qualified tax advisor before claiming a bad debt deduction to avoid running afoul of IRS regulations.