Page 42

subsequently becomes worthless, the most you’re allowed to deduct is the amount you paid to acquire it. You can claim a business bad debt de- duction only if the amount owed to you was previously included in gross in- come. This applies to amounts owed to you from all sources of taxable income, including sales, services, rents, and interest. Accrual method. If you use an accrual method of accounting, you generally report in- come as you earn it. You can only claim a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income. If you qualify, you can use the nonac- crual-experience method of accounting dis- cussed later. Under this method, you don’t have to accrue income that, based on your experi- ence, you don’t expect to collect. Cash method. If you use the cash method of accounting, you generally report income when you receive payment. You can’t claim a bad debt deduction for amounts owed to you because you never included those amounts in income. For example, a cash basis architect can’t claim a bad debt deduction if a client fails to pay the bill because the architect's fee was never included in income. Debts from a former business. If you sell your business but retain its receivables, these debts are business debts because they arose out of your trade or business. If any of these re- ceivables subsequently become worthless, the loss is still a business bad debt. Debt acquired from a decedent. The character of a loss from debts of a business ac- quired from a decedent is determined in the same way as debts acquired on the purchase of a business. The executor of the decedent's es- tate treats any loss from the debts as a busi- ness bad debt if the debts were closely related to the decedent's trade or business when they became worthless. Otherwise, a loss from these debts becomes a nonbusiness bad debt for the decedent's estate. Liquidation. If you liquidate your business and some of the accounts receivable that you retain become worthless, they’re treated as business bad debts. Types of Business Bad Debts Business bad debts may result from the follow- ing. Loans to clients and suppliers. If you loan money to a client, supplier, employee, or distrib- utor for a business reason and you’re unable to collect the loan after attempting to do so, you have a business bad debt. Debts owed by political parties. If a political party (or other organization that accepts contri- butions or spends money to influence elections) owes you money and the debt becomes worth- less, you can claim a bad debt deduction only if all of the following requirements are met. CAUTION ! 1. You use an accrual method of accounting. 2. The debt arose from the sale of goods or services in the ordinary course of your trade or business. 3. More than 30% of your receivables ac- crued in the year of the sale were from sales to political parties. 4. You made substantial and continuing ef- forts to collect on the debt. Loan or capital contribution. You cannot claim a bad debt deduction for a loan you made to a corporation if, based on the facts and cir- cumstances, the loan is actually a contribution to capital. Debts of an insolvent partner. If your busi- ness partnership breaks up and one of your for- mer partners becomes insolvent, you may have to pay more than your pro rata share of the part- nership's debts. If you pay any part of the insol- vent 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. Business loan guarantee. 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. • You made the guarantee in the course of your trade or business. • You have a legal duty to pay the debt. • You made the guarantee before the debt became worthless. You meet this require- ment if you reasonably expected you wouldn’t have to pay the debt without full reimbursement from the borrower. • You received reasonable consideration for making the guarantee. You meet this re- quirement if you made the guarantee ac- cording to normal business practice or for a good faith business purpose. Example. Jane Zayne owns the Zayne Dress Company. She guaranteed payment of a $20,000 note for Elegant Fashions, a dress out- let. Elegant Fashions is one of Zayne's largest clients. Elegant Fashions later defaulted on the loan. As a result, Ms. Zayne paid the remaining balance of the loan in full to the bank. She can claim a business bad debt deduc- tion only for the amount she paid because her guarantee was made in the course of her trade or business for a good faith business purpose. She was motivated by the desire to retain one of her better clients and keep a sales outlet. Deductible in the year paid. If you make a payment on a loan you guaranteed, you can de- duct it in the year paid, unless you have rights against the borrower. Rights against a borrower. When you make payment on a loan you guaranteed, you may have the right to take the place of the lender. The debt is then owed to you. If you have this right, or some other right to demand payment from the borrower, you can’t claim a bad debt deduction until these rights become partly or totally worthless. Joint debtor. If two or more debtors jointly owe you money, your inability to collect from one doesn’t enable you to deduct a proportion- ate amount as a bad debt. Sale of mortgaged property. If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt. When a Debt Becomes Worthless A debt becomes worthless when there is no longer any chance the amount owed will be paid. This may occur on the date the debt is due or prior to that date. To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. It isn’t necessary to go to court if you can show that a judgment from the court would be uncollectible. Bankruptcy of your debtor is gen- erally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt. Property received for debt. If you receive property in partial settlement of a debt, reduce the debt by the property's FMV, which becomes the property's basis. You can deduct the re- maining debt as a bad debt if and when it be- comes worthless. If you later sell the property for more than its basis, any gain on the sale is due to the appre- ciation of the property. It isn’t a recovery of a bad debt. For information on the sale of an as- set, see Pub. 544. How To Claim a Business Bad Debt There are two methods to claim a business bad debt. • The specific charge-off method. • The nonaccrual-experience method. Generally, you must use the specific charge-off method. However, you may use the nonac- crual-experience method if you meet the re- quirements discussed later under Nonac- crual-Experience Method. Specific Charge-off Method If you use the specific charge-off method, you can deduct specific business bad debts that be- come either partly or totally worthless during the tax year. However, with respect to partly worth- less bad debts, your deduction is limited to the amount you charged off on your books during the year. Partly worthless debts. You can deduct spe- cific bad debts that become partly uncollectible during the tax year. Your tax deduction is limi- ted to the amount you charge off on your books during the year. You don’t have to charge off and deduct your partly worthless debts annu- ally. You can delay the charge-off until a later year. However, you can’t deduct any part of a debt after the year it becomes totally worthless. Chapter 10 Business Bad Debts Page 41