As is the case with most tax rules, the IRS expects your company to meet certain requirements if you want to take a bad-debt deduction. First, you must be structured as an accrual-basis business, which means sales are taxable and expenses are deductible when incurred.
Business owners with companies that use the cash-basis method of accounting, in which income is taxable upon receipt and expenses are deductible when paid, are often surprised that they aren't permitted to take a deduction for bad debts, says tax agent Jan Zobel, who owns a tax preparation and consulting business in Oakland, California. Zobel provides tax advice to self-employed business owners and is the author of Minding Her Own Business: The Self-Employed Woman's Guide to Taxes and Recordkeeping (Easthill Press).
One of Zobel's clients, an attorney who uses the cash method of accounting, was particularly disappointed when he discovered he couldn't claim a deduction for the $17,000 he was unable to collect from a client in bankruptcy proceedings. Zobel says the only items her client was able to deduct were expenses related to the legal work he did for the client. Now her client is standing in line with the client's other creditors to try to collect the balance of his debt.
While it may be tempting to sneak in a bad-debt deduction even if they're not eligible, owners of cash-basis companies should resist the urge, says Susan Jacksack, a small-business analyst with CCH Inc., a provider of legal, tax and business information in Riverwoods, Illinois. Trying to claim this deduction if you're a cash-basis company has been known to trigger an IRS audit, she says.
Even if you're an accrual-basis company, to qualify for the deduction, the debt must have been either created or acquired in your business or been closely related to your business when it became partly or totally worthless.
If the debt in question doesn't fall into one of those categories, the IRS considers it a nonbusiness bad debt, which doesn't trigger the same tax benefits. Nonbusiness bad debts are treated as short-term capital losses, says Jacksack. If the capital loss exceeds the capital gain, only $3,000 of the loss can be used against ordinary income in any given year. Any excess is carried forward and can be used in future years.
With a business bad debt, however, the entire amount can be deducted in the year the debt becomes totally worthless. The IRS says it's also possible to receive a partial deduction for a partially worthless business debt. A nonbusiness bad debt, on the other hand, has to be totally worthless in order to be deducted.