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Can I Take a Bad Debt Deduction?

When you make a loan that’s not paid back or are unable to collect outstanding invoice in your business, the tax laws sometimes allow you to take a bad debt deduction. If and how you take the bad debt deduction depends on whether it relates to a business, an investment or a personal loan. Under each scenario, the tax savings can be a little different, and in some cases, won’t save you any income tax at all.

Bad Debts & Business

When a bad debt is the result of a business transaction, the IRS allows you to treat is as a business bad debt, which are subject to more advantageous tax laws. You can treat a default or uncollectible account as a business bad debt if your sole motive for engaging in the underlying transaction is to ultimately increase the profits of your business, even if indirectly. To illustrate, suppose you own a small accounting firm and give one of your employees a $2,500 loan to prepare and take the CPA exam. Despite the fact this isn’t a transaction that accountants enter into on a regular basis, it’s still a business bad debt if the employee quits and fails to pay the money back. However, the more common transaction leading to a bad deduction is a client who never makes payment on an invoice for tax preparation services.

When is It a Worthless Debt

Before any type of bad debt is deductible, the IRS requires that you determine it to be a worthless debt first. A debt becomes worthless at the moment you realize that there’s very little possibility of being paid back. There isn’t a hard-and-fast rule to reference for making this decision, but generally, it’s reasonable to consider a debt worthless when the debtor is past-due and you’ve made a number of unsuccessful attempts to collect it. However, there’s no requirement that you wait months before deeming the debt worthless and taking a bad debt deduction. For example, it’s unlikely the IRS will challenge your deduction if you make a business loan one week before the debtor files for bankruptcy.

Uncollectible Personal Loans

When no business purpose exists for making a loan, you’ll need to establish whether you had an investment motive, such as to earn interest, or if it was made to help a friend or family member out. Personal loans you make without a business or investment motive are unable to satisfy the IRS requirement that a legitimate debtor-creditor relationship exist before you can take a bad debt deduction. A debtor-creditor relationship tends to exists when there’s a promissory note that makes repaying the loan unconditional, regardless of whether you charge interest or not. The only way to establish this is with the existence of loan terms that make repayment of the loan unconditional. If the promissory note is vague or allows the debtor to make payments at their convenience without adverse consequences, it starts to look like a personal loan that is treated as a nondeductible gift when there is a default.

Taking Bad Debt Deductions

The tax form where you report a bad debt deduction depends whether it relates to a business or personal investment. When it’s a “nonbusiness bad debt,” you report the unpaid amount as a short term capital loss on your personal tax return, which then requires preparation of a Schedule D and IRS Form 8949. The bad debt deduction will reduce the capital gains you report, with up to $3,000 of the excess loss taken as a deduction against your ordinary income each tax year. If the bad debt relates to your business, you report it on the relevant tax form for the type of business entity you use. This includes Form 1120 if a corporation, a 1065 for a partnership or a Schedule C when using a sole proprietorship. Note, however, that an LLC is eligible to use any of these three tax forms since the IRS doesn’t have an LLC-specific tax form.

Reference: IRS Publication 550-Investment Income and Expenses