Bad debt losses are likely to occur in this COVID-19 ravaged economy. Some have already happened. More will surely be on the way. This column covers federal income tax issues in an FAQ format. Here it goes. The IRS is often skeptical when taxpayers claim deductions for bad debt losses. Reason: Losses from alleged loan transactions are often due to some other type of financial move gone wrong. For example, you may have made a capital contribution to a business entity that turned out to be a loser. Or you could have advanced cash to a friend or relative in the unrealistic hope that the money would be returned without receiving anything in writing. Since these things happen all the time, you can’t really blame the IRS for the bad attitude.
So here’s the deal: To claim a deductible bad debt loss that will survive IRS scrutiny, be prepared to show that the loss was actually from an unfortunate loan rather than something else that turned out to be a very bad idea. For tips on how to do this, check out this Tax Guy above. What are the tax rules for individual insolvency losses? Assuming you can establish that you made a legitimate loan that is now past due, the next question is whether you have a business bad debt loss or a non-business bad debt loss. As you will see, this is a very important distinction under tax rules. Losses classified as business bad debt Bad debt losses arising in the course of the business of an individual taxpayer are treated as ordinary losses and can generally be deducted in full without any limitation. Okay. Additionally, you can claim a partial worthlessness deduction for business debt that goes partially wrong. Also good. The big exception to this favorable taxpayer treatment is when you have a loss on an unfortunate loan to your employer. That is an unreimbursed employee business expense. Before the Tax Cuts and Jobs Act (TCJA), you could deduct unreimbursed employee business expenses, along with miscellaneous other expenses, to the extent that the total exceeded 2% of your adjusted gross income (AGI) . However, the TCJA suspended these deductions for 2018-2025. Therefore, if you have a loss on an unfortunate loan to your employer, you cannot claim any federal income tax deductions under current rules. I’m sorry. Losses Classified as Non-Business Bad Debt Losses Most commonly, an individual’s bad debt loss does not arise in the course of the individual’s business. In this case, the loss is classified as a short-term capital loss. As such, it is subject to the capital loss deduction limitations. You can first use a short-term capital loss to offset any capital gains from other sources. You can then deduct any remaining capital loss of up to $ 3,000 from other income, or $ 1,500 if you use separate filing status. After that, any remaining principal loss from a non-business bad debt carries over to the next tax year and is subject to the same deduction limitations once again. So if you have a large non-business bad debt loss and capital gains that amount to little or nothing, it can take years to fully deduct the bad debt loss. Finally, no deduction is allowed until the year a non-business debt becomes completely worthless. What about bad debt losses suffered by my business? In this situation a more favorable tax treatment is applied. Your business can claim an ordinary loss, which can usually be fully deducted. Claim the deduction for ordinary losses in the tax year when the bad debt of the company becomes completely worthless. The write-off is generally equal to: (1) the face amount of the debt or the remaining balance of the debt if you have received principal payments or (2) for trade purposes or accounts payable, the uncollected amount that your business has recognized previously as taxable income. If you receive a property as partial payment for a business debt, the loss is reduced by the property’s fair market value. Effect of Your Business Tax Accounting Method Many small businesses, including nearly all sole proprietorships, use the cash method of accounting for federal income tax purposes. For a cash method taxpayer, a bad debt arising from non-payment of services cannot be deducted because your business has not recognized any taxable income for services. Therefore, the debt has no tax basis. Therefore, no deduction is allowed. The same occurs with worthless debts for unpaid installments, unpaid income or similar elements that have not been recognized as taxable income in the fiscal year in which the uselessness is established or in a previous year. On the other hand, if your business uses the accrual method of accounting for tax purposes, you can generally deduct a bad debt loss in the year that worthlessness is established. Example 1: For profit, LLC (FP) uses the cash method of accounting for tax purposes. In 2020, FP bills a customer $ 50,000 for services rendered. The customer never pays the bill. By 2021 it is clear that all collection efforts are doomed. However, FP cannot claim a bad debt deduction for the $ 50,000 lost, because that amount was never included in taxable income. The debt had no tax basis, so no deduction is allowed. Example 2: All About Profit, PSC (AAP) uses the accrual method of accounting for tax purposes. In 2020, AAP bills a customer for $ 100,000 for services and reports that amount as taxable income on their 2020 federal income tax return. By the end of 2021, all efforts to collect the $ 100,000 receivable have failed. AAP can claim a $ 100,000 bad debt deduction in 2021 Partially worthless business debt deductions Assuming we are talking about business debt that has a tax base, you can deduct part of that base in the tax year when the debt becomes partially useless. However, you must be prepared to show that partial futility has occurred and you must disclose the amount that you have actually loaded on your company’s books. Please note that your business is not required to claim a tax year deduction when a debt partially loses its value. You cannot deduct anything or you can deduct all or part of the amount that is loaded on the books that year. Alternatively, you can simply deduct all of the debt in the tax year when it is worthless. The Net Operating Loss (NOL) Factor for Business Bad Debts The Coronavirus Relief, Relief and Economic Security Act (CARES Act) allows a five-year repayment privilege for a business net operating loss (NOL) that arose in a tax year beginning in 2020. Claiming a business bad debt deduction for that year can potentially create or increase a NOL for that year. If so, the NOL can be carried over for up to five years and you can recover some or all of the federal income tax paid for the year of return. This factor argues in favor of claiming 2020 bad debt deductions for any debt that you can reasonably argue went wrong that year. What if I’m not sure when a debt is worthless? Right. Sometimes it is difficult to prove that a debt is worthless in a particular tax year. In the case of an audit, the IRS could take the position that the worthlessness occurred one year prior to the year you claimed the bad debt deduction. To protect taxpayers from losing fair deductions for bad debts because the statute of limitations for amending returns has expired, a special provision of the Tax Code extends the statute of limitations for claiming deductions for bad debts from the standard from three years to seven years. . In effect, you can jump into a time machine and go back up to seven years to claim a bad debt deduction by modifying the yield for the year the debt went bad.