Kristina Stamatis, BridgeTower Media Newswires
Many companies consider it common practice to estimate the amount of accounts receivable at year end that they believe to be uncollectible. This amount is then "written off" as bad debt expense. In recent years the service has placed an increased scrutiny on this deduction, reminding taxpayers that an estimate of uncollectible accounts receivable is not allowed, that one must analyze the individual underlying debts.
Code section 166 allows a deduction for debt that becomes worthless. This is referred to as a "bad debt deduction." There are three criteria that must be met to claim a bad debt deduction. First, the taxpayer must establish that the claim is for a bona fide debt. Second, the taxpayer must determine whether the debt is business debt or non-business debt. Third, the taxpayer must establish that the debt has become worthless, and the deduction must be claimed at the proper time and in the proper manner.
The term "bona fide debt" is defined as "a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money."
There are various factors to consider in determining whether a bona fide debt exists for purposes of the bad debt deduction, including whether the parties intended to create a debtor-creditor relationship, whether the parties executed a written agreement evidencing their intent, whether the advance was made with a reasonable expectation of repayment, whether collateral was provided to secure the debt, whether a fixed maturity date existed and whether interest was charged.
The second criteria to be met before determining if the debt is worthless is determining whether a debt is a business debt or a non-business debt.
In general, business debt is debt incurred in connection with operating a trade or business. Non-business debt is defined broadly as everything else. The reason this distinction is important is because business bad debts are treated as ordinary losses, whereas non-business bad debts are treated as short-term capital losses and are subject to the related capital loss limitations. In addition, non-business bad debts may be deducted only when wholly worthless, as opposed to business bad debts that may be deducted when partially worthless or wholly worthless. It is important to note that bad debts of C corporations are treated as business bad debts. S corporations, other business entities, and individuals may have business bad debts or non-business bad debts.
Finally it must be determined if the debt is worthless. The Code does not define the term "worthlessness," but instead refers to "evidence of worthlessness." Therefore a taxpayer must consider all of the relevant facts and circumstances when determining whether a debt is worthless, in whole or in part. The following list of events may help substantiate worthlessness, though no single factor is determinative.
Is the debtor insolvent? Ceased business activities? Died or become impaired? Held assets that have significantly declined in value?
Not all events in proving worthlessness rest with the debtor however. The taxpayer may need to prove that they have actively pursued payment. Also, if the taxpayer has continued to transact business with the debtor, that most likely will cast doubt as to worthlessness.
Once it has been established that evidence of worthlessness exists, the taxpayer must determine if the debt is wholly or partially worthless.
A taxpayer claims a deduction for wholly worthless debt in the tax year the debt becomes wholly worthless. In order to claim a deduction for wholly worthless debt, the taxpayer must establish that the debt held some value at the beginning of the tax year, but held no value by the end of the tax year. The taxpayer also must establish that specifically identifiable events caused the debt to become worthless during the tax year.
Before the taxpayer can deduct a partially worthless business debt, it must be able to show that partial worthlessness has occurred and the amount of partial worthlessness that has been charged off on the books of the business. The taxpayer may choose from among the following options concerning how to handle the debt for tax purposes:
The taxpayer may claim a deduction for any portion of the debt, up to the amount actually written off its books during the year. The requirement to record a book charge-off means the portion charged off must no longer appear as an asset in the business's financial records or on its financial statements. However, it does not mean the business must cancel the debt or notify the debtor of the charge-off. The taxpayer may still continue its collection efforts while claiming a tax deduction for a partially worthless debt.
The business can always forgo a current-year tax deduction in favor of waiting until the balance of the debt is either collected or determined to be worthless. It can claim a bad debt deduction for the entire uncollected amount at that time. Deferring this deduction may be prove to be a beneficial tax planning strategy.
The taxpayer may treat each partially worthless debt differently. However, in no case may the taxpayer claim a tax deduction any later than the year in which a debt becomes completely worthless. The business is not required to make an actual charge-off on its books to claim a bad debt deduction for a wholly worthless debt. However, it may want to do so in case the IRS later asserts the debt was only partially worthless and disallows even a partial deduction since no charge-off occurred. (A deduction for a partially worthless debt is limited to the amount actually charged-off on the business's books.)
The bottom line is taxpayers may claim a deduction for debt that has become worthless if claimed at the proper time and in the proper manner. In claiming the deduction, consideration should be given to the type of debt, the extent to which the debt has become worthless, and how the debt has been treated for book purposes. Taxpayers should consult their tax adviser to consider other related issues such as the treatment of the reserve as well as the potential need for a change in accounting method.
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Kristina S. Stamatis, CPA is a senior manager with Mengel, Metzger, Barr & Co. LLP, and can be reached at Kstamatis@ mmb-co.com.
Published: Mon, Feb 06, 2017
