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Taxact2012Taxact2012 10. Taxact2012 Business Bad Debts Table of Contents Introduction Topics - This chapter discusses: Useful Items - You may want to see: Definition of Business Bad DebtAccrual method. Taxact2012 Cash method. Taxact2012 Debt acquired from a decedent. Taxact2012 Liquidation. Taxact2012 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. Taxact2012 Introduction You have a bad debt if you cannot collect money owed to you. Taxact2012 A bad debt is either a business bad debt or a nonbusiness bad debt. Taxact2012 This chapter discusses only business bad debts. Taxact2012 Generally, a business bad debt is one that comes from operating your trade or business. Taxact2012 You can deduct business bad debts on Schedule C (Form 1040) or your applicable business income tax return. Taxact2012 All other bad debts are nonbusiness bad debts and are deductible only as short-term capital losses. Taxact2012 For more information on nonbusiness bad debts, see Publication 550. Taxact2012 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. Taxact2012 S. Taxact2012 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. Taxact2012 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. Taxact2012 A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. Taxact2012 Bad debts of a corporation (other than an S corporation) are always business bad debts. Taxact2012 Credit sales. Taxact2012 Business bad debts are mainly the result of credit sales to customers. Taxact2012 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. Taxact2012 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. Taxact2012 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. Taxact2012 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. Taxact2012 You can claim a business bad debt deduction only if the amount owed to you was previously included in gross income. Taxact2012 This applies to amounts owed to you from all sources of taxable income, including sales, services, rents, and interest. Taxact2012 Accrual method. Taxact2012 If you use the accrual method of accounting, you generally report income as you earn it. Taxact2012 You can only claim a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income. Taxact2012 If you qualify, you can use the nonaccrual-experience method of accounting discussed later. Taxact2012 Under this method, you do not have to accrue income that, based on your experience, you do not expect to collect. Taxact2012 Cash method. Taxact2012 If you use the cash method of accounting, you generally report income when you receive payment. Taxact2012 You cannot claim a bad debt deduction for amounts owed to you because you never included those amounts in income. Taxact2012 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. Taxact2012 Debts from a former business. Taxact2012 If you sell your business but retain its receivables, these debts are business debts because they arose out of your trade or business. Taxact2012 If any of these receivables subsequently become worthless, the loss is still a business bad debt. Taxact2012 Debt acquired from a decedent. Taxact2012 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. Taxact2012 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. Taxact2012 Otherwise, a loss from these debts becomes a nonbusiness bad debt for the decedent's estate. Taxact2012 Liquidation. Taxact2012 If you liquidate your business and some of the accounts receivable that you retain become worthless, they become business bad debts. Taxact2012 Types of Business Bad Debts Business bad debts may result from the following. Taxact2012 Loans to clients and suppliers. Taxact2012 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. Taxact2012 Debts owed by political parties. Taxact2012 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. Taxact2012 You use the accrual method of accounting. Taxact2012 The debt arose from the sale of goods or services in the ordinary course of your trade or business. Taxact2012 More than 30% of your receivables accrued in the year of the sale were from sales to political parties. Taxact2012 You made substantial and continuing efforts to collect on the debt. Taxact2012 Loan or capital contribution. Taxact2012 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. Taxact2012 Debts of an insolvent partner. Taxact2012 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. Taxact2012 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. Taxact2012 Business loan guarantee. Taxact2012 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. Taxact2012 You made the guarantee in the course of your trade or business. Taxact2012 You have a legal duty to pay the debt. Taxact2012 You made the guarantee before the debt became worthless. Taxact2012 You meet this requirement if you reasonably expected you would not have to pay the debt without full reimbursement from the borrower. Taxact2012 You received reasonable consideration for making the guarantee. Taxact2012 You meet this requirement if you made the guarantee in accord with normal business practice or for a good faith business purpose. Taxact2012 Example. Taxact2012 Jane Zayne owns the Zayne Dress Company. Taxact2012 She guaranteed payment of a $20,000 note for Elegant Fashions, a dress outlet. Taxact2012 Elegant Fashions is one of Zayne's largest clients. Taxact2012 Elegant Fashions later defaulted on the loan. Taxact2012 As a result, Ms. Taxact2012 Zayne paid the remaining balance of the loan in full to the bank. Taxact2012 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. Taxact2012 She was motivated by the desire to retain one of her better clients and keep a sales outlet. Taxact2012 Deductible in the year paid. Taxact2012 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. Taxact2012 Rights against a borrower. Taxact2012 When you make payment on a loan you guaranteed, you may have the right to take the place of the lender. Taxact2012 The debt is then owed to you. Taxact2012 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. Taxact2012 Joint debtor. Taxact2012 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. Taxact2012 Sale of mortgaged property. Taxact2012 If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt. Taxact2012 When a Debt Becomes Worthless A debt becomes worthless when there is no longer any chance the amount owed will be paid. Taxact2012 This may occur when the debt is due or prior to that date. Taxact2012 To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. Taxact2012 It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. Taxact2012 Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt. Taxact2012 Property received for debt. Taxact2012 If you receive property in partial settlement of a debt, reduce the debt by the property's FMV, which becomes the property's basis. Taxact2012 You can deduct the remaining debt as a bad debt if and when it becomes worthless. Taxact2012 If you later sell the property for more than its basis, any gain on the sale is due to the appreciation of the property. Taxact2012 It is not a recovery of a bad debt. Taxact2012 For information on the sale of an asset, see Publication 544. Taxact2012 How To Claim a Business Bad Debt There are two methods to claim a business bad debt. Taxact2012 The specific charge-off method. Taxact2012 The nonaccrual-experience method. Taxact2012 Generally, you must use the specific charge-off method. Taxact2012 However, you may use the nonaccrual-experience method if you meet the requirements discussed later under Nonaccrual-Experience Method . Taxact2012 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. Taxact2012 However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the year. Taxact2012 Partly worthless debts. Taxact2012 You can deduct specific bad debts that become partly uncollectible during the tax year. Taxact2012 Your tax deduction is limited to the amount you charge off on your books during the year. Taxact2012 You do not have to charge off and deduct your partly worthless debts annually. Taxact2012 You can delay the charge off until a later year. Taxact2012 However, you cannot deduct any part of a debt after the year it becomes totally worthless. Taxact2012 Significantly modified debt. Taxact2012 An exception to the charge-off rule exists for debt which has been significantly modified and on which the holder recognized gain. Taxact2012 For more information, see Regulations section 1. Taxact2012 166-3(a)(3). Taxact2012 Deduction disallowed. Taxact2012 Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. Taxact2012 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. Taxact2012 The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year. Taxact2012 Totally worthless debts. Taxact2012 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. Taxact2012 You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. Taxact2012 However, you may want to do so. Taxact2012 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. Taxact2012 See Partly worthless debts, earlier. Taxact2012 Filing a claim for refund. Taxact2012 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. Taxact2012 If the bad debt was totally worthless, you must file the claim by the later of the following dates. Taxact2012 7 years from the date your original return was due (not including extensions). Taxact2012 2 years from the date you paid the tax. Taxact2012 If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates. Taxact2012 3 years from the date you filed your original return. Taxact2012 2 years from the date you paid the tax. Taxact2012 You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. Taxact2012 Such an impairment requires proof of existence. Taxact2012 For details and more information about filing a claim, see Publication 556. Taxact2012 Use one of the following forms to file a claim. Taxact2012 For more information, see the instructions for the applicable form. Taxact2012 Table 10-1. Taxact2012 Forms Used To File a Claim IF you filed as a. Taxact2012 . Taxact2012 . Taxact2012 THEN file. Taxact2012 . Taxact2012 . Taxact2012 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. Taxact2012 Under this method, you do not accrue service related income you expect to be uncollectible. Taxact2012 Because the expected uncollectible amounts are not included in income, these amounts are not later deducted from income. Taxact2012 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. Taxact2012 Service related income. Taxact2012 You can use the nonaccrual-experience method only for amounts earned by performing services. Taxact2012 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. Taxact2012 Gross receipts test. Taxact2012 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. Taxact2012 If your average annual gross receipts for any year exceeds $5 million, you cannot use the non-accural experience method. Taxact2012 The average annual gross receipts for any year is the average of gross receipts from the year in question and the 2 previous years. Taxact2012 For example, if you were figuring the average annual gross receipts for 2013, you would average your gross receipts for 2011, 2012, and 2013. Taxact2012 Interest or penalty charged. Taxact2012 Generally, you cannot use the nonaccrual-experience method for amounts due on which you charge interest or a late payment penalty. Taxact2012 However, do not treat a discount offered for early payment as the charging of interest or a penalty if both the following apply. Taxact2012 You otherwise accrue the full amount due as gross income at the time you provide the services. Taxact2012 You treat the discount allowed for early payment as an adjustment to gross income in the year of payment. Taxact2012 Change in accounting method. Taxact2012 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. Taxact2012 See Form 3115 and the Instructions for Form 3115 for more information. Taxact2012 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. Taxact2012 The amount you include is limited to the amount you actually deducted. Taxact2012 However, you can exclude the amount deducted that did not reduce your tax. Taxact2012 Report the recovery as “Other income” on the appropriate business form or schedule. Taxact2012 See Recoveries in Publication 525 for more information. Taxact2012 Net operating loss (NOL) carryover. Taxact2012 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. Taxact2012 A bad debt deduction that contributes to a NOL helps lower taxes in the year to which you carry the NOL. Taxact2012 For more information about NOLs, see Publication 536. Taxact2012 Also, see the Instructions for Form 1045, and the Instructions for Form 1139. Taxact2012 Prev Up Next Home More Online Publications
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