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Tax Trade-offs for Business Bad Debts

Suppose one of your regular clients or vendors is experiencing economic difficulties. You have let the account slide for awhile on several invoices, but now you are concerned that you may never be paid. So you decide to wholeheartedly pursue collection efforts.

Tax payoff: You can deduct a business bad debt in a year that it becomes worthless. To prove that a given debt is worthless this year, you must show that you legitimately tried to collect it this year. Otherwise, you receive no deduction at all.

For example, you should keep detailed records of all of your efforts to be repaid, including copies of letters, phone calls, e-mails and collection agency documentation. Set up file folders for all your debt collection activities. Hold onto these records for at least three years in case the IRS challenges the deductions.

The accounting method for business bad debts is called the “specific charge-off method” because it requires you to identify specific debts and charge them off the books (i.e., remove the debts as assets). With the specific charge-off method, you can deduct business bad debts that are either partially worthless or totally worthless. (Non-business bad debts can be deducted only when they become totally worthless.)

Partially worthless debts: This gives you more flexibility than a totally worthless debt. You can charge off the part of the debt that is uncollectible and claim the deduction in the same year or the following year. For instance, you might postpone the write-off if you expect next year to be a high-income year for your business. Alternatively, you can wait until the debt becomes totally worthless.

Totally worthless debts: These must be deducted in the year that they become worthless. The deduction cannot include any amount previously deducted as a partially worthless debt. You are not required to actually write off the debts on your books, but you are advised to do so: If the IRS subsequently rules that a debt is only partially worthless, you cannot claim any deduction until the year of the charge-off.

What happens if you deduct a bad debt and then recover some or all of it in a later year? You must report the recovery as taxable income, but only up to the amount that reduced your tax liability for the year of the write-off.

Example: Say that you are self-employed and incurred a $10,000 bad debt last year. After claiming itemized deductions and personal exemptions, the debt reduces your taxable income by $6,000. If the $10,000 debt is repaid in full in 2006, you report $6,000 in additional taxable income on your 2006 return.

It is particularly important for self-employed individuals to establish that bad debts are related to their business and are not considered personal debts.

Note: Unlike business bad debts that are deducted against business income, non-business bad debts are treated as capital losses. You must first use them to offset capital gains and then up to $3,000 of ordinary income on your personal tax return. Therefore, business bad debts are more valuable tax-wise than non-business debts.

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	[ return to list ] Tax Trade-offs for Business Bad Debts Suppose one of your regular clients or vendors is experiencing economic difficulties. You have let the account slide for awhile on several invoices, but now you are concerned that you may never be paid. So you decide to wholeheartedly pursue collection efforts. Tax payoff: You can deduct a business bad debt in a year that it becomes worthless. To prove that a given debt is worthless this year, you must show that you legitimately tried to collect it this year. Otherwise, you receive no deduction at all. For example, you should keep detailed records of all of your efforts to be repaid, including copies of letters, phone calls, e-mails and collection agency documentation. Set up file folders for all your debt collection activities. Hold onto these records for at least three years in case the IRS challenges the deductions. The accounting method for business bad debts is called the “specific charge-off method” because it requires you to identify specific debts and charge them off the books (i.e., remove the debts as assets). With the specific charge-off method, you can deduct business bad debts that are either partially worthless or totally worthless. (Non-business bad debts can be deducted only when they become totally worthless.) Partially worthless debts: This gives you more flexibility than a totally worthless debt. You can charge off the part of the debt that is uncollectible and claim the deduction in the same year or the following year. For instance, you might postpone the write-off if you expect next year to be a high-income year for your business. Alternatively, you can wait until the debt becomes totally worthless. Totally worthless debts: These must be deducted in the year that they become worthless. The deduction cannot include any amount previously deducted as a partially worthless debt. You are not required to actually write off the debts on your books, but you are advised to do so: If the IRS subsequently rules that a debt is only partially worthless, you cannot claim any deduction until the year of the charge-off. What happens if you deduct a bad debt and then recover some or all of it in a later year? You must report the recovery as taxable income, but only up to the amount that reduced your tax liability for the year of the write-off. Example: Say that you are self-employed and incurred a $10,000 bad debt last year. After claiming itemized deductions and personal exemptions, the debt reduces your taxable income by $6,000. If the $10,000 debt is repaid in full in 2006, you report $6,000 in additional taxable income on your 2006 return. It is particularly important for self-employed individuals to establish that bad debts are related to their business and are not considered personal debts. Note: Unlike business bad debts that are deducted against business income, non-business bad debts are treated as capital losses. You must first use them to offset capital gains and then up to $3,000 of ordinary income on your personal tax return. Therefore, business bad debts are more valuable tax-wise than non-business debts. [ return to list ]
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