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EztaxformEztaxform 10. Eztaxform Business Bad Debts Table of Contents Introduction Topics - This chapter discusses: Useful Items - You may want to see: Definition of Business Bad DebtAccrual method. Eztaxform Cash method. Eztaxform Debt acquired from a decedent. Eztaxform Liquidation. Eztaxform Types of Business Bad Debts When a Debt Becomes Worthless How To Claim a Business Bad DebtSpecific Charge-Off Method Nonaccrual-Experience Method Recovery of a Bad DebtNet operating loss (NOL) carryover. Eztaxform Introduction You have a bad debt if you cannot collect money owed to you. Eztaxform A bad debt is either a business bad debt or a nonbusiness bad debt. Eztaxform This chapter discusses only business bad debts. Eztaxform Generally, a business bad debt is one that comes from operating your trade or business. Eztaxform You can deduct business bad debts on Schedule C (Form 1040) or your applicable business income tax return. Eztaxform All other bad debts are nonbusiness bad debts and are deductible only as short-term capital losses. Eztaxform For more information on nonbusiness bad debts, see Publication 550. Eztaxform Topics - This chapter discusses: Definition of business bad debt When a debt becomes worthless How to claim a business bad debt Recovery of a bad debt Useful Items - You may want to see: Publication 525 Taxable and Nontaxable Income 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts 544 Sales and Other Dispositions of Assets 550 Investment Income and Expenses 556 Examination of Returns, Appeal Rights, and Claims for Refund Form (and Instructions) Schedule C (Form 1040) Profit or Loss From Business 1040X Amended U. Eztaxform S. Eztaxform Individual Income Tax Return 1045 Application for Tentative Refund 1139 Corporation Application for Tentative Refund 3115 Application for Change in Accounting Method See chapter 12 for information about getting publications and forms. Eztaxform Definition of Business Bad Debt A business bad debt is a loss from the worthlessness of a debt that was either: Created or acquired in your trade or business, or Closely related to your trade or business when it became partly or totally worthless. Eztaxform A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. Eztaxform Bad debts of a corporation (other than an S corporation) are always business bad debts. Eztaxform Credit sales. Eztaxform Business bad debts are mainly the result of credit sales to customers. Eztaxform Goods that have been sold, but not yet paid for, and services that have been performed, but not yet paid for, are recorded in your books as either accounts receivable or notes receivable. Eztaxform After a reasonable period of time, if you have tried to collect the amount due, but are unable to do so, the uncollectible part becomes a business bad debt. Eztaxform Accounts or notes receivable valued at fair market value (FMV) when received are deductible only at that value, even though the FMV may be less than the face value. Eztaxform If you purchased an account receivable for less than its face value, and the receivable subsequently becomes worthless, the most you are allowed to deduct is the amount you paid to acquire it. Eztaxform You can claim a business bad debt deduction only if the amount owed to you was previously included in gross income. Eztaxform This applies to amounts owed to you from all sources of taxable income, including sales, services, rents, and interest. Eztaxform Accrual method. Eztaxform If you use the accrual method of accounting, you generally report income as you earn it. Eztaxform You can only claim a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income. Eztaxform If you qualify, you can use the nonaccrual-experience method of accounting discussed later. Eztaxform Under this method, you do not have to accrue income that, based on your experience, you do not expect to collect. Eztaxform Cash method. Eztaxform If you use the cash method of accounting, you generally report income when you receive payment. Eztaxform You cannot claim a bad debt deduction for amounts owed to you because you never included those amounts in income. Eztaxform For example, a cash basis architect cannot claim a bad debt deduction if a client fails to pay the bill because the architect's fee was never included in income. Eztaxform Debts from a former business. Eztaxform If you sell your business but retain its receivables, these debts are business debts because they arose out of your trade or business. Eztaxform If any of these receivables subsequently become worthless, the loss is still a business bad debt. Eztaxform Debt acquired from a decedent. Eztaxform The character of a loss from debts of a business acquired from a decedent is determined in the same way as debts acquired on the purchase of a business. Eztaxform The executor of the decedent's estate treats any loss from the debts as a business bad debt if the debts were closely related to the decedent's trade or business when they became worthless. Eztaxform Otherwise, a loss from these debts becomes a nonbusiness bad debt for the decedent's estate. Eztaxform Liquidation. Eztaxform If you liquidate your business and some of the accounts receivable that you retain become worthless, they become business bad debts. Eztaxform Types of Business Bad Debts Business bad debts may result from the following. Eztaxform Loans to clients and suppliers. Eztaxform If you loan money to a client, supplier, employee, or distributor for a business reason and you are unable to collect the loan after attempting to do so, you have a business bad debt. Eztaxform Debts owed by political parties. Eztaxform If a political party (or other organization that accepts contributions or spends money to influence elections) owes you money and the debt becomes worthless, you can claim a bad debt deduction only if all of the following requirements are met. Eztaxform You use the accrual method of accounting. Eztaxform The debt arose from the sale of goods or services in the ordinary course of your trade or business. Eztaxform More than 30% of your receivables accrued in the year of the sale were from sales to political parties. Eztaxform You made substantial and continuing efforts to collect on the debt. Eztaxform Loan or capital contribution. Eztaxform You cannot claim a bad debt deduction for a loan you made to a corporation if, based on the facts and circumstances, the loan is actually a contribution to capital. Eztaxform Debts of an insolvent partner. Eztaxform If your business partnership breaks up and one of your former partners becomes insolvent, you may have to pay more than your pro rata share of the partnership's debts. Eztaxform If you pay any part of the insolvent partner's share of the debts, you can claim a bad debt deduction for the amount you paid that is attributable to the insolvent partner's share. Eztaxform Business loan guarantee. Eztaxform If you guarantee a debt that subsequently becomes worthless, the debt can qualify as a business bad debt if all the following requirements are met. Eztaxform You made the guarantee in the course of your trade or business. Eztaxform You have a legal duty to pay the debt. Eztaxform You made the guarantee before the debt became worthless. Eztaxform You meet this requirement if you reasonably expected you would not have to pay the debt without full reimbursement from the borrower. Eztaxform You received reasonable consideration for making the guarantee. Eztaxform You meet this requirement if you made the guarantee in accord with normal business practice or for a good faith business purpose. Eztaxform Example. Eztaxform Jane Zayne owns the Zayne Dress Company. Eztaxform She guaranteed payment of a $20,000 note for Elegant Fashions, a dress outlet. Eztaxform Elegant Fashions is one of Zayne's largest clients. Eztaxform Elegant Fashions later defaulted on the loan. Eztaxform As a result, Ms. Eztaxform Zayne paid the remaining balance of the loan in full to the bank. Eztaxform She can claim a business bad debt deduction only for the amount she paid, since her guarantee was made in the course of her trade or business for a good faith business purpose. Eztaxform She was motivated by the desire to retain one of her better clients and keep a sales outlet. Eztaxform Deductible in the year paid. Eztaxform If you make a payment on a loan you guaranteed, you can deduct it in the year paid, unless you have rights against the borrower. Eztaxform Rights against a borrower. Eztaxform When you make payment on a loan you guaranteed, you may have the right to take the place of the lender. Eztaxform The debt is then owed to you. Eztaxform If you have this right, or some other right to demand payment from the borrower, you cannot claim a bad debt deduction until these rights become partly or totally worthless. Eztaxform Joint debtor. Eztaxform If two or more debtors jointly owe you money, your inability to collect from one does not enable you to deduct a proportionate amount as a bad debt. Eztaxform Sale of mortgaged property. Eztaxform If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt. Eztaxform When a Debt Becomes Worthless A debt becomes worthless when there is no longer any chance the amount owed will be paid. Eztaxform This may occur when the debt is due or prior to that date. Eztaxform To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. Eztaxform It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. Eztaxform Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt. Eztaxform Property received for debt. Eztaxform If you receive property in partial settlement of a debt, reduce the debt by the property's FMV, which becomes the property's basis. Eztaxform You can deduct the remaining debt as a bad debt if and when it becomes worthless. Eztaxform If you later sell the property for more than its basis, any gain on the sale is due to the appreciation of the property. Eztaxform It is not a recovery of a bad debt. Eztaxform For information on the sale of an asset, see Publication 544. Eztaxform How To Claim a Business Bad Debt There are two methods to claim a business bad debt. Eztaxform The specific charge-off method. Eztaxform The nonaccrual-experience method. Eztaxform Generally, you must use the specific charge-off method. Eztaxform However, you may use the nonaccrual-experience method if you meet the requirements discussed later under Nonaccrual-Experience Method . Eztaxform Specific Charge-Off Method If you use the specific charge-off method, you can deduct specific business bad debts that become either partly or totally worthless during the tax year. Eztaxform However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the year. Eztaxform Partly worthless debts. Eztaxform You can deduct specific bad debts that become partly uncollectible during the tax year. Eztaxform Your tax deduction is limited to the amount you charge off on your books during the year. Eztaxform You do not have to charge off and deduct your partly worthless debts annually. Eztaxform You can delay the charge off until a later year. Eztaxform However, you cannot deduct any part of a debt after the year it becomes totally worthless. Eztaxform Significantly modified debt. Eztaxform An exception to the charge-off rule exists for debt which has been significantly modified and on which the holder recognized gain. Eztaxform For more information, see Regulations section 1. Eztaxform 166-3(a)(3). Eztaxform Deduction disallowed. Eztaxform Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. Eztaxform If, under audit, the IRS does not allow your deduction and the debt becomes partly worthless in a later tax year, you can deduct the amount you charged off in that year plus the disallowed amount charged off in the earlier year. Eztaxform The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year. Eztaxform Totally worthless debts. Eztaxform If a debt becomes totally worthless in the current tax year, you can deduct the entire amount, less any amount deducted in an earlier tax year when the debt was only partly worthless. Eztaxform You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. Eztaxform However, you may want to do so. Eztaxform If you do not and the IRS later rules the debt is only partly worthless, you will not be allowed a deduction for the debt in that tax year because a deduction of a partly worthless bad debt is limited to the amount actually charged off. Eztaxform See Partly worthless debts, earlier. Eztaxform Filing a claim for refund. Eztaxform If you did not deduct a bad debt on your original return for the year it became worthless, you can file a claim for a credit or refund. Eztaxform If the bad debt was totally worthless, you must file the claim by the later of the following dates. Eztaxform 7 years from the date your original return was due (not including extensions). Eztaxform 2 years from the date you paid the tax. Eztaxform If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates. Eztaxform 3 years from the date you filed your original return. Eztaxform 2 years from the date you paid the tax. Eztaxform You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. Eztaxform Such an impairment requires proof of existence. Eztaxform For details and more information about filing a claim, see Publication 556. Eztaxform Use one of the following forms to file a claim. Eztaxform For more information, see the instructions for the applicable form. Eztaxform Table 10-1. Eztaxform Forms Used To File a Claim IF you filed as a. Eztaxform . Eztaxform . Eztaxform THEN file. Eztaxform . Eztaxform . Eztaxform Sole proprietor or farmer Form 1040X Corporation Form 1120X S corporation Form 1120S and check box H(4) Partnership Form 1065X if filing on paper or Form 1065 and check box G(5) if filing electronically Nonaccrual-Experience Method If you use an accrual method of accounting and qualify under the rules explained in this section, you can use the nonaccrual-experience method for bad debts. Eztaxform Under this method, you do not accrue service related income you expect to be uncollectible. Eztaxform Because the expected uncollectible amounts are not included in income, these amounts are not later deducted from income. Eztaxform Generally, you can use the nonaccrual-experience method for accounts receivable for services you performed only if: The services are provided in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, or the performing arts, or You meet the $5 million gross receipts test for all prior years. Eztaxform Service related income. Eztaxform You can use the nonaccrual-experience method only for amounts earned by performing services. Eztaxform You cannot use this method for amounts owed to you from activities such as lending money, selling goods, or acquiring receivables or other rights to receive payment. Eztaxform Gross receipts test. Eztaxform To find out if you meet the $5 million gross receipts test for all prior years, you must figure the average annual gross receipts for each prior year. Eztaxform If your average annual gross receipts for any year exceeds $5 million, you cannot use the non-accural experience method. Eztaxform The average annual gross receipts for any year is the average of gross receipts from the year in question and the 2 previous years. Eztaxform For example, if you were figuring the average annual gross receipts for 2013, you would average your gross receipts for 2011, 2012, and 2013. Eztaxform Interest or penalty charged. Eztaxform Generally, you cannot use the nonaccrual-experience method for amounts due on which you charge interest or a late payment penalty. Eztaxform However, do not treat a discount offered for early payment as the charging of interest or a penalty if both the following apply. Eztaxform You otherwise accrue the full amount due as gross income at the time you provide the services. Eztaxform You treat the discount allowed for early payment as an adjustment to gross income in the year of payment. Eztaxform Change in accounting method. Eztaxform Generally, you must obtain consent to change to a nonaccrual-experience method (other than one of the safe harbor methods) or to change from one method to another. Eztaxform See Form 3115 and the Instructions for Form 3115 for more information. Eztaxform Recovery of a Bad Debt If you claim a deduction for a bad debt on your income tax return and later recover (collect) all or part of it, you may have to include all or part of the recovery in gross income. Eztaxform The amount you include is limited to the amount you actually deducted. Eztaxform However, you can exclude the amount deducted that did not reduce your tax. Eztaxform Report the recovery as “Other income” on the appropriate business form or schedule. Eztaxform See Recoveries in Publication 525 for more information. Eztaxform Net operating loss (NOL) carryover. Eztaxform If a bad debt deduction increases an NOL carryover that has not expired before the beginning of the tax year in which the recovery takes place, you treat the deduction as having reduced your tax. Eztaxform A bad debt deduction that contributes to a NOL helps lower taxes in the year to which you carry the NOL. Eztaxform For more information about NOLs, see Publication 536. Eztaxform Also, see the Instructions for Form 1045, and the Instructions for Form 1139. Eztaxform Prev Up Next Home More Online Publications
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