Bad debt losses are likely to occur in this COVID-19-ravaged economy. Some have already happened. More are surely on the way. This column covers the federal income tax issues in FAQ format. Here goes.
Why does the IRS look askance at individual bad debt write-offs?
The IRS is often skeptical when taxpayers claim deductions for bad debt losses. Reason: losses from purported loan transactions are often from some other type of financial move that went sour. For instance, you might have actually made a contribution to the capital of a business entity that turned out to be a loser. Or you might have advanced cash to a friend or relative with the unrealistic hope that the money would be paid back without getting anything in writing. Since these things happen all the time, you really can’t blame the IRS for the bad attitude.
So here’s the deal: to claim a deductible bad debt loss that will survive IRS scrutiny, be prepared to prove that the loss was actually from an ill-fated loan instead of from something else that turned out to be a really bad idea. For advice on how to do that, see this previous Tax Guy.
What are the tax rules for individual bad debt losses?
Assuming you can establish that you made a legitimate loan that has now gone bad, the next question is whether you have a business bad debt loss or a non-business bad debt loss. As you will see, this is a very important distinction under the tax rules.
Losses classified as business bad debt losses
Losses from bad debts that arise in the course of an individual taxpayer’s business activity are treated as ordinary losses and can usually be fully deducted without any limitations. Good. In addition, you can claim a partial worthlessness deduction for a business debt that goes partially bad. Also good.
The big exception to this taxpayer-friendly treatment is when you have a loss from an ill-fated loan to your employer. That’s an unreimbursed employee business expense. Before the Tax Cuts and Jobs Act (TCJA), you could deduct unreimbursed employee business expenses, along with certain other miscellaneous expenses, to the extent the total exceeded 2% of your adjusted gross income (AGI). However, the TCJA suspended these deductions for 2018-2025. So, if you have a loss from an ill-fated loan to your employer, you cannot claim any federal income tax deduction under the current rules. Sorry.
Losses classified as non-business bad debt losses
More commonly, an individual’s bad debt loss does not arise in the course of the individual’s business. In this case, the loss is classified as short-term capital loss. As such, it’s subject to the capital loss deduction limitations. You can first use a short-term capital loss to offset any capital gains from other sources. Next, you can deduct any remaining capital loss against up to $3,000 of other income, or $1,500 if you use married filing separate status. After that, any remaining capital loss from a non-business bad debt is carried over to the next tax year and subjected to the same deduction limitations all over again.
So, if you have a big non-business bad debt loss and capital gains that amount to little or nothing, it can take years to fully deduct the bad debt loss. Finally, no deduction is allowed until the year when a non-business debt becomes completely worthless.
What about bad debt losses suffered by my business?
More favorable tax treatment applies in this situation. Your business can claim an ordinary loss, which can usually be fully deducted. Claim the ordinary loss deduction in the tax year when the business bad debt becomes completely worthless. The write-off generally equals: (1) the face amount of the debt or the remaining debt balance if you’ve received principal payments or (2) for trade notes or payables, the uncollected amount that your business has previously recognized as taxable income. If you receive property in partial payment of a business debt, the loss is reduced by the fair market value of the property.
Effect of your business’s tax accounting method
Many small businesses, including almost all sole proprietorships, use the cash method of accounting for federal income tax purposes. For a cash-method taxpayer, a bad debt arising from the failure to be paid for services cannot be deducted, because your business has not recognized any taxable income from the services. Therefore, the debt has no tax basis. Therefore, no deduction is allowed. Ditto for worthless debts from unpaid fees, unpaid rents, or similar items that have not been recognized as taxable income in the tax year when worthlessness is established or an earlier year.
On the other hand, if your business uses the accrual method of accounting for tax purposes, you can generally deduct a bad debt loss in the year when worthlessness is established.
Example 1: For Profit, LLC (FP) uses the cash method of accounting for tax purposes. In 2020, FP bills a client $50,000 for services rendered. The client never pays the bill. In 2021 it becomes clear that all collection efforts are doomed to failure. However, FP cannot claim a bad debt deduction for the lost $50,000, because that amount was never included in taxable income. The debt had no tax basis, so no deduction is allowed.
Example 2: All About Profit, PSC (AAP) uses the accrual method of accounting for tax purposes. In 2020, AAP bills a customer $100,000 for services and reports that amount as taxable income on its 2020 federal income tax return. By the end of 2021, all efforts to collect the $100,000 receivable have failed. AAP can claim a $100,000 bad debt deduction in 2021.
Deductions for partially worthless business debts
Assuming we are talking about a business debt that has tax basis, you can deduct part of that basis in the tax year when the debt becomes partially worthless. However, you must be prepared to show that partial worthlessness has occurred, and you must disclose the amount that you’ve actually charged off on your business’s books.
Note that your business is not required to claim a deduction in the tax year when a debt becomes partially worthless. You can deduct nothing, or you can deduct all or any part of the amount that’s charged off on the books in that year. Alternatively, you can simply deduct the entire debt in the tax year when it becomes wholly worthless.
The net operating loss (NOL) factor for business bad debts
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) allows a five-year carryback privilege for a business net operating loss (NOL) that arose in a tax year beginning in 2020. Claiming a business bad debt deduction for that year can potentially create or increase an NOL for that year. If so, the NOL can be carried back for up to five years, and you can recover some or all of the federal income tax paid for the carryback year. This factor argues in favor of claiming 2020 bad debt deductions for any debts that you can reasonably argue went bad in that year.
What if I’m not sure when a debt became worthless?
Right. It’s sometimes difficult to prove that a debt became worthless in a particular tax year. In the event of an audit, the IRS might take the position that worthlessness occurred in a year earlier than the year in which you claimed the bad debt deduction. To protect taxpayers from losing righteous bad debt deductions because the statute of limitations for amending returns has expired, a special Tax Code provision extends the statute of limitations for claiming bad debt deductions from the standard three years to seven years. In effect, you can hop into a time machine and go back up to seven years to claim a bad debt deduction by amending the return for the year the debt went bad.
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