Income Tax in the USA: Bad Debt Deductions
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In computing income tax in the USA, taxpayers may claim a deduction for business debts that become worthless during the year. {26 USC 166} The amount of deduction is the taxpayer’s basis in the debt. A taxpayer must demonstrate that a particular debt became worthless during the year in order to claim the deduction. The debt owed to the taxpayer must have become worth nothing, not just declined in value. Taxpayers may not claim deductions for reserves related to bad debts, only for specific bad debts. The portion of a specific debt that is charged off (abandoned) during a year may be deducted, subject to IRS approval as to validity of the charge off and the amount.
For the taxpayer to get a deduction, two conditions must exist:
- The taxpayer must have basis in a debt, and
- The debt must have become worthless during the year.
What Is a Debt?
A business debt is any amount owed to a taxpayer that arose in connection with a trade or business. This includes an account or note receivable from sale of goods, performance of services, rental or provision of property, or any other business activity. The form of the debt is usually irrelevant. Thus an informal promise to pay a fee for professional services is a debt owed to the professional under the terms of the informal promise.
Amount of Bad Debt Deduction
A deduction for bad debts or worthlessness is allowed only for the taxpayer’s basis in the property. Debts are property in the hands of the holder of the debt (the creditor), but are not property in the hands of the borrower or issuer of the debt. {Cleveland, Painesville, and Ashtabula Railroad Company v. Pennsylvania, 82 US 179 (1873)} A holder of debt has basis by virtue of either buying the debt (or otherwise acquiring it in a transaction that gives rise to basis) or by having recognized income in transactions giving rise to the debt. An accrual basis business has basis in amounts receivable from customers to the extent the business recognized income. Thus, sale of inventory for a promise to pay gives a business basis in the resulting account receivable.
Example: Punchy Papers sells $1,000 of paper inventory to Small’s Office Supply in January on open account. In February, Punchy issues a credit memo to Small’s for $80, for a net balance due of $920. Punchy recognized $1,000 of sales in January and $80 of returns and allowances in February. Punchy’s basis is the receivable from Small’s is $920. See Income Tax in the USA, Chapter 32, Accounting Periods and Methods, regarding Punchy’s requirement to use the accrual method with respect to sales of inventory.
Individuals, partnerships of individuals, and smaller corporations may use the cash method of accounting for everything except inventories and sales of inventory in computing income tax in the USA. Such businesses do not have basis in amounts receivable from customers for other than sales of inventory, with one exception. Where income has been recognized on receipt of a check or other instrument or charge to a credit card, the cash basis business has a deductible bad debt if the check, instrument, or charge card is dishonored. For example, Glitz Diner takes a customer’s check on December 31 in payment for dinner, and treated it as income. Glitz deposits the check at the end of the following week, and the next week the check bounces. Glitz can deduct as a business bad debt the amount of the check that was included in December 31 income.
When To Take the Deduction
A bad debt deduction is claimed in the tax year during which the taxpayer determines the debt cannot be collected. {26 CFR 1.166-2} To get the deduction, the debt must have zero value, not just be worth less than basis. In the example above, if in December Mr. Small tells Punchy he will only pay $500 of the bill, absent other evidence of worthlessness Punchy cannot take a deduction. The deduction for the remaining $420 can be claimed only when Small fails to pay.
Worthlessness of a debt is a factual question. It is not necessary that the debtor be insolvent or have declared bankruptcy. Nor is it necessary that the creditor exhaust all legal recourses to collect the debt. Each of these, however, helps to establish that the debt is worthless. It is up to the taxpayer to prove the debt is worthless.
Reserves
Accounting rules require that an enterprise reduce the carrying value of assets where they are impaired. Under these rules, a bad debt expense is often recognized and a reserve (contra-asset) established. This reserve is often determined based on the experience and judgment of management.
U.S. income tax rules prohibit deducting this expense computed as a reserve (but see the exceptions below). {Note: 26 CFR 1.166-4 was repealed by PL 99-514} To claim a deduction for a bad debt, specific items of debt must be identified as worthless.
Example: Big Wholesale has thousands of customers, and sells on open account. Big’s experience indicates that each year about 2% of customers will fail to pay. Big accrues bad debt expense of 2% of sales for its financial statements. For its tax returns, Big may deduct as bad debts only those accounts receivable which have become uncollectible. Its deduction for tax purposes will likely differ from the expense recognized for financial reporting.
Exceptions apply for banks and for businesses that provide services to customers or clients. Banks compute bad debt deductions under a reserve method, the amount of which is governed by banking regulators. Taxpayers providing services to others for a fee may adopt the “nonaccrual-experience method” of accounting under which a portion of revenues is not accrued. The method applies only to accrual method corporations providing health, law, engineering, architecture, accounting, actuarial, consulting, or performing arts services. Under the method, the taxpayer computes the portion of accounts receivable that are expected to be uncollectible based on the business’s experience. A safe harbor formula is generally used where the amount of reserve at year end equals year end receivables times a ratio. Several different safe harbor ratios are available, including bad debts less recoveries divided by revenues. Each term in the ratio is computed based on a moving average of three to six years. Taxpayers using the method must document re-testing of ratios every three years. {26 USC 448(d)(5); 26 CFR 1.448-2}
Prove It!
Maintaining a paper trail is critical to getting bad debt deductions if the IRS comes calling. Best practices include compiling the following information before filing a tax return:
– Name of each debtor owing a debt considered bad
– Amount owed to taxpayer
– Date the amount was included in income or acquired
– Date the amount was due
– Reason the debt is considered bad
– For each substantial debt, a narrative of the efforts taken to collect the debt
– Copy of invoice(s) or other evidence of the debt
It is not necessary that all amounts by a particular customer be uncollectible for a particular amount to be uncollectible. The bad debt may be limited to a particular invoice, or even a line item on an invoice or even a portion of an invoice. If a customer writes that he won’t pay for a particular item because it was no good, then the amount due from that customer for that item may be a deductible bad debt. If the customer returns the item and is issued a refund, the amount should be considered a refund (reduction of sales) rather than a bad debt.
Recovery of Bad Debts
Sometimes customers pay an amount even after a business has determined it won’t get paid. If the business had claimed a deduction for a bad debt in a prior year, the recovery of that debt is income. Bad debt recoveries are generally reported as other income on a tax return.
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