If you run a business, sooner or later you’ll probably encounter a client who doesn’t pay his bills. Fortunately, all is not lost. While you may have no hope of ever receiving the money, the IRS does allow you to take a bad debt deduction. If the bad debt is personal, it’s trickier.
TL;DR (Too Long; Didn't Read)
Writing off an uncollectible debt on taxes depends on whether the debt is business or personal. For bad business debts, much depends on the type of accounting method used.
Bad Debt Write Off
Examples of bad business debts include sales on credit to customers, business loan guarantees and loans you may have made to a supplier or client. If you are in the business of lending money, unpaid loans are bad business debts. You must have documentation regarding the loan or sale. In a loan situation, a formal loan agreement is preferable, but other evidence that the money changing hands was a loan and not a gift is acceptable. You must show that you attempted to collect the debt and that it is uncollectible. The IRS does allow deductibility of partial business debt losses. If you lent an entity $1,500, and it paid you $750 but reneged on the rest of the debt, then you can write off the unpaid $750. The IRS doesn’t usually include unpaid wages, rents, benefits and the like as bad debts.
Warning Signs of Bad Debts
A business shouldn’t make a loan or issue credit to a party that it doesn’t think will repay the debt. If the loan is not repaid on time, there are red flags indicating the debt may end up uncollectible outside of actual bankruptcy. These include the inability to communicate with the debtor, whether it’s a matter of phone calls, emails or letters unanswered. Obviously, if a company or individual simply disappears, that’s a warning that your debt will likely go unpaid. Sometimes, you’ll be told outright that no payment is forthcoming. You might decide to hire a collection agency to go after the debtor. The collection agency charges a fee for debt collection, usually a percentage of the amount collected. If a professional collection agency cannot get the money owed from a debtor, you have an excellent argument that the debt is uncollectible.
Cash Basis vs. Accrual Accounting
If you are a cash basis business, you only record income once it is received. That’s a problem in trying to write off a bad debt, as you can’t count money as owed if you never got it. However, there are no taxes due on income you didn’t receive. You aren’t eligible to take a bad debt deduction.
If you use the accrual method of accounting, an unpaid bill is considered income on which tax is owed. If the funds are uncollectible, you can write them off as a bad debt. Wait until the end of the year to tally all bad debts owed just in case some are paid, but make an effort to collect unpaid bills as soon as they are overdue. In general, a business debt isn’t considered bad per se unless it has not been paid within 90 days.
Nonbusiness Bad Loans
If you’ve lent money to a friend or relative and the debt is not repaid, writing if off becomes more complicated. When it comes to writing off a personal bad debt rather than one that is business related, the IRS might allow you to take a bad debt credit on your tax return. However, the rules for what the IRS considers a bad personal debt are quite stringent, and many people may not qualify based on the way they loaned the money. For example, if your best friend needs $1,000 in an emergency and you simply write her a check, you probably can’t write this debt off when she doesn’t pay you back. If there is no loan agreement with terms, she can claim the money was a gift.
If you do have a document stating the amount of the loan and that it was to be repaid, you are on firmer ground, but that’s just the beginning. Along with the loan amount, the agreement must include the name of the debtor. The IRS will only permit you to take a bad debt credit if you can prove you tried to collect on the debt and failed. Keep copies of all emails or letters written to the person regarding debt payment and take notes on any phone conversations, including the date and time. You must also show the IRS that the debt is completely worthless. There’s no partial deductibility for a personal bad debt. If your friend went bankrupt, you can provide a copy of the bankruptcy documentation, but if your friend is simply a deadbeat, that’s harder to prove. You don’t have to go to court to try to collect a judgement as long as you can show the IRS that a court judgement would still make it impossible to collect the money.
Keep in mind that the IRS must have tough regulations in place when it comes to personal bad loans, or else people would come out of the woodwork trying to get a deduction for a so-called bad debt.
Where to Deduct Bad Debts
If you are a sole proprietor, deduct your bad debt on Form 1040 Schedule C, Profit or Loss from Business. If your business consists of another entity, deduct the bad debt on the appropriate form.
To receive a bad debt credit for a personal bad debt, submit Form 8949, Sales and Other Disposition of Capital Assets. It is considered a short-term capital loss, and the amount is credited against any capital gains for that tax year. If you did not have any capital gains, or this amount was smaller than the bad debt, you can use the loss to reduce up to $3,000 of other income. If the debt was greater than $3,000, you can carry the amount forward on future tax returns.
Enter the debtor’s name and attach a bad debt statement. You’ll need to detail every aspect of the bad debt situation, including your efforts to collect and why the debt is uncollectible. For the latter, you must make your case as to why the debt is totally worthless. Along with the amount due, you must include the date the debt was due. You must also identify the relationship between yourself and the debtor, such as family member or friend. You can only claim a bad debt credit in the year the debt was due. If you have already filed your return and then realized the debt was uncollectible and worthless, you may file an amended return, Form 1040-X, along with Form 8949.
If Debt Is Repaid
What happens if you take a bad debt deduction and the borrower suddenly pays up? When that occurs, you must include the repayment as taxable income. The only taxable part of such income, however, is the amount of the bad debt that ended up as a tax reduction. For example, if the bad debt was worth $4,000 and you took $3,000 off your other income, the taxable income is $3,000, not $4,000. If you were charging interest on the debt and that was paid, you must report the interest amount on your tax return.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.