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