Deducting Bad Debt
Can you deduct a bad debt? Yes, if it is a business bad debt and a non-business bad debt under certain conditions. A business bad debt occurs when the debt was created or acquired in a trade or business closely related to your pre-existing trade or business and it becomes partially or totally worthless.
The test for closely related debt is if your primary motivation for incurring the debt is business related. Take the deduction on 1040 schedule C or on your other business tax return.
Debts from clients, suppliers, distributors and employees, credit sales to customers and business loan guarantees are all considered business bad debts.
Essentially all other bad debts are considered non-business. For a nonbusiness bad debt to be deductible, the debt must be considered completely worthless. Partially worthless nonbusiness debt is not deductible. Claim non-business bad debt on form 8849.
When a debt becomes worthless depends on the facts and circumstances. Did you take steps to collect the debt? You do not have to go to court or obtained a judgment. What reasonable efforts were made? The answer determines the deductibility. If you anticipate the debt will become worthless and you meet the other requires, you can claim it as a deduction, however you can only take the deduction in the year it becomes worthless. Debt maturity is not required to be considered worthless.
Claiming a bad debt deduction for a shareholder loan to a corporation, the same rules apply as a business debt above. Courts consider the following:
- Does documentation of the obligation exist?
- Is there a repayment schedule inducing maturity date?
- Is interest being charged?
- Was the debt secured by collateral?
- Were collection efforts documented?
- Was any portion of the debt repaid?
- How did the parties to the transaction record the debt?
- Was there a reasonable expectation of collection from the debtor at the time the debt was created, i.e. what was the financial condition of the debtor?
Of particular concern is whether the transaction was a loan or an equity investment. Equity investments are not deductible as bad debts. Proper documentation is critical in establishing a debtor/creditor relationship vs. equity investment.