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Is it a Bad Debt or a Simple Revenue Loss? Telling the Difference

April 16, 2012

You gave someone money or offered them credit. They never paid you back. Can you deduct the loss on your income taxes?

Offering credit to customers can be a good thing for your business. It increases your accounts receivable. It can lock in a long-term relationship with a customer. It provides extra income in the form of finance charges. And it promotes good will for your company.


But how do you reflect the loss on your business income taxes if this money isn't paid back? If you are structured as any kind of corporation other than an S Corporation, all uncollectible debt is considered business bad debt.


According to the IRS, you have a business bad debt if:

  • The debt was formalized as gross income from sources like sales, service, rents or interest, and was recorded using the accrual method

  • The financial obligation was created or acquired in the course of operating your company, or you took it on primarily for business-related reasons.

If an unpaid financial obligation meets certain conditions, the IRS consider it a business bad debt.


Bad debt that does not fit this definition is considered nonbusiness bad debt, and can be deducted as a short-term capital loss. Many restrictions apply here.


Credit Often Responsible


Credit is usually the culprit, and a debtor bankruptcy is often the reason for the financial default. If not, you must be able to prove that you took reasonable steps to collect on the obligation. You can consider the debt worthless even prior to the debt's due date if you've done so.


Business bad debts are entered on the IRS Form 1040X (sole proprietor or farmer), Form 1120X (corporation), Form 1120S (S corporation) or Form 1065 (partnership). Most businesses will use the specific charge-off method to claim the debt, but you may qualify for the nonaccrual-experience method. 


This element of your business income tax preparation is quite complex; we can help you sort it out. Give us a call.

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