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1040ez Forms1040ez forms 10. 1040ez forms Business Bad Debts Table of Contents Introduction Topics - This chapter discusses: Useful Items - You may want to see: Definition of Business Bad DebtAccrual method. 1040ez forms Cash method. 1040ez forms Debt acquired from a decedent. 1040ez forms Liquidation. 1040ez forms 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. 1040ez forms Introduction You have a bad debt if you cannot collect money owed to you. 1040ez forms A bad debt is either a business bad debt or a nonbusiness bad debt. 1040ez forms This chapter discusses only business bad debts. 1040ez forms Generally, a business bad debt is one that comes from operating your trade or business. 1040ez forms You can deduct business bad debts on Schedule C (Form 1040) or your applicable business income tax return. 1040ez forms All other bad debts are nonbusiness bad debts and are deductible only as short-term capital losses. 1040ez forms For more information on nonbusiness bad debts, see Publication 550. 1040ez forms 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. 1040ez forms S. 1040ez forms 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. 1040ez forms 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. 1040ez forms A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. 1040ez forms Bad debts of a corporation (other than an S corporation) are always business bad debts. 1040ez forms Credit sales. 1040ez forms Business bad debts are mainly the result of credit sales to customers. 1040ez forms 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. 1040ez forms 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. 1040ez forms 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. 1040ez forms 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. 1040ez forms You can claim a business bad debt deduction only if the amount owed to you was previously included in gross income. 1040ez forms This applies to amounts owed to you from all sources of taxable income, including sales, services, rents, and interest. 1040ez forms Accrual method. 1040ez forms If you use the accrual method of accounting, you generally report income as you earn it. 1040ez forms You can only claim a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income. 1040ez forms If you qualify, you can use the nonaccrual-experience method of accounting discussed later. 1040ez forms Under this method, you do not have to accrue income that, based on your experience, you do not expect to collect. 1040ez forms Cash method. 1040ez forms If you use the cash method of accounting, you generally report income when you receive payment. 1040ez forms You cannot claim a bad debt deduction for amounts owed to you because you never included those amounts in income. 1040ez forms 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. 1040ez forms Debts from a former business. 1040ez forms If you sell your business but retain its receivables, these debts are business debts because they arose out of your trade or business. 1040ez forms If any of these receivables subsequently become worthless, the loss is still a business bad debt. 1040ez forms Debt acquired from a decedent. 1040ez forms 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. 1040ez forms 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. 1040ez forms Otherwise, a loss from these debts becomes a nonbusiness bad debt for the decedent's estate. 1040ez forms Liquidation. 1040ez forms If you liquidate your business and some of the accounts receivable that you retain become worthless, they become business bad debts. 1040ez forms Types of Business Bad Debts Business bad debts may result from the following. 1040ez forms Loans to clients and suppliers. 1040ez forms 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. 1040ez forms Debts owed by political parties. 1040ez forms 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. 1040ez forms You use the accrual method of accounting. 1040ez forms The debt arose from the sale of goods or services in the ordinary course of your trade or business. 1040ez forms More than 30% of your receivables accrued in the year of the sale were from sales to political parties. 1040ez forms You made substantial and continuing efforts to collect on the debt. 1040ez forms Loan or capital contribution. 1040ez forms 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. 1040ez forms Debts of an insolvent partner. 1040ez forms 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. 1040ez forms 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. 1040ez forms Business loan guarantee. 1040ez forms 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. 1040ez forms You made the guarantee in the course of your trade or business. 1040ez forms You have a legal duty to pay the debt. 1040ez forms You made the guarantee before the debt became worthless. 1040ez forms You meet this requirement if you reasonably expected you would not have to pay the debt without full reimbursement from the borrower. 1040ez forms You received reasonable consideration for making the guarantee. 1040ez forms You meet this requirement if you made the guarantee in accord with normal business practice or for a good faith business purpose. 1040ez forms Example. 1040ez forms Jane Zayne owns the Zayne Dress Company. 1040ez forms She guaranteed payment of a $20,000 note for Elegant Fashions, a dress outlet. 1040ez forms Elegant Fashions is one of Zayne's largest clients. 1040ez forms Elegant Fashions later defaulted on the loan. 1040ez forms As a result, Ms. 1040ez forms Zayne paid the remaining balance of the loan in full to the bank. 1040ez forms 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. 1040ez forms She was motivated by the desire to retain one of her better clients and keep a sales outlet. 1040ez forms Deductible in the year paid. 1040ez forms 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. 1040ez forms Rights against a borrower. 1040ez forms When you make payment on a loan you guaranteed, you may have the right to take the place of the lender. 1040ez forms The debt is then owed to you. 1040ez forms 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. 1040ez forms Joint debtor. 1040ez forms 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. 1040ez forms Sale of mortgaged property. 1040ez forms If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt. 1040ez forms When a Debt Becomes Worthless A debt becomes worthless when there is no longer any chance the amount owed will be paid. 1040ez forms This may occur when the debt is due or prior to that date. 1040ez forms To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. 1040ez forms It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. 1040ez forms Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt. 1040ez forms Property received for debt. 1040ez forms If you receive property in partial settlement of a debt, reduce the debt by the property's FMV, which becomes the property's basis. 1040ez forms You can deduct the remaining debt as a bad debt if and when it becomes worthless. 1040ez forms If you later sell the property for more than its basis, any gain on the sale is due to the appreciation of the property. 1040ez forms It is not a recovery of a bad debt. 1040ez forms For information on the sale of an asset, see Publication 544. 1040ez forms How To Claim a Business Bad Debt There are two methods to claim a business bad debt. 1040ez forms The specific charge-off method. 1040ez forms The nonaccrual-experience method. 1040ez forms Generally, you must use the specific charge-off method. 1040ez forms However, you may use the nonaccrual-experience method if you meet the requirements discussed later under Nonaccrual-Experience Method . 1040ez forms 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. 1040ez forms However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the year. 1040ez forms Partly worthless debts. 1040ez forms You can deduct specific bad debts that become partly uncollectible during the tax year. 1040ez forms Your tax deduction is limited to the amount you charge off on your books during the year. 1040ez forms You do not have to charge off and deduct your partly worthless debts annually. 1040ez forms You can delay the charge off until a later year. 1040ez forms However, you cannot deduct any part of a debt after the year it becomes totally worthless. 1040ez forms Significantly modified debt. 1040ez forms An exception to the charge-off rule exists for debt which has been significantly modified and on which the holder recognized gain. 1040ez forms For more information, see Regulations section 1. 1040ez forms 166-3(a)(3). 1040ez forms Deduction disallowed. 1040ez forms Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. 1040ez forms 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. 1040ez forms The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year. 1040ez forms Totally worthless debts. 1040ez forms 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. 1040ez forms You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. 1040ez forms However, you may want to do so. 1040ez forms 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. 1040ez forms See Partly worthless debts, earlier. 1040ez forms Filing a claim for refund. 1040ez forms 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. 1040ez forms If the bad debt was totally worthless, you must file the claim by the later of the following dates. 1040ez forms 7 years from the date your original return was due (not including extensions). 1040ez forms 2 years from the date you paid the tax. 1040ez forms If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates. 1040ez forms 3 years from the date you filed your original return. 1040ez forms 2 years from the date you paid the tax. 1040ez forms You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. 1040ez forms Such an impairment requires proof of existence. 1040ez forms For details and more information about filing a claim, see Publication 556. 1040ez forms Use one of the following forms to file a claim. 1040ez forms For more information, see the instructions for the applicable form. 1040ez forms Table 10-1. 1040ez forms Forms Used To File a Claim IF you filed as a. 1040ez forms . 1040ez forms . 1040ez forms THEN file. 1040ez forms . 1040ez forms . 1040ez forms 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. 1040ez forms Under this method, you do not accrue service related income you expect to be uncollectible. 1040ez forms Because the expected uncollectible amounts are not included in income, these amounts are not later deducted from income. 1040ez forms 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. 1040ez forms Service related income. 1040ez forms You can use the nonaccrual-experience method only for amounts earned by performing services. 1040ez forms 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. 1040ez forms Gross receipts test. 1040ez forms 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. 1040ez forms If your average annual gross receipts for any year exceeds $5 million, you cannot use the non-accural experience method. 1040ez forms The average annual gross receipts for any year is the average of gross receipts from the year in question and the 2 previous years. 1040ez forms For example, if you were figuring the average annual gross receipts for 2013, you would average your gross receipts for 2011, 2012, and 2013. 1040ez forms Interest or penalty charged. 1040ez forms Generally, you cannot use the nonaccrual-experience method for amounts due on which you charge interest or a late payment penalty. 1040ez forms However, do not treat a discount offered for early payment as the charging of interest or a penalty if both the following apply. 1040ez forms You otherwise accrue the full amount due as gross income at the time you provide the services. 1040ez forms You treat the discount allowed for early payment as an adjustment to gross income in the year of payment. 1040ez forms Change in accounting method. 1040ez forms 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. 1040ez forms See Form 3115 and the Instructions for Form 3115 for more information. 1040ez forms 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. 1040ez forms The amount you include is limited to the amount you actually deducted. 1040ez forms However, you can exclude the amount deducted that did not reduce your tax. 1040ez forms Report the recovery as “Other income” on the appropriate business form or schedule. 1040ez forms See Recoveries in Publication 525 for more information. 1040ez forms Net operating loss (NOL) carryover. 1040ez forms 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. 1040ez forms A bad debt deduction that contributes to a NOL helps lower taxes in the year to which you carry the NOL. 1040ez forms For more information about NOLs, see Publication 536. 1040ez forms Also, see the Instructions for Form 1045, and the Instructions for Form 1139. 1040ez forms Prev Up Next Home More Online Publications
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