Deduct Your Business Bad Debts - By: StrataTax

In today’s uncertain economic climate, more companies are suffering from business bad debts. A business bad debt is money that is owed to your business that you are not going to be able to collect. To partially offset the negative impact bad debt have on your business, the IRS allows you to deduct business bad debts on your business income tax return.

To be considered a business bad debt for tax purposes, the debt must have been either created or acquired in your trade or business or closely related to your trade or business when it became partly or totally worthless. A debt is considered related to your trade or business if your primary motive for incurring the debt was business related. Business bad debts generally stem from performing credit sales to customers. The amount of debt that becomes uncollectible becomes a business bad debt. It is important to note that in order to claim a bad debt deduction, the amount owed to you must have been previously included in gross income.

When a Debt can be Considered Worthless. For tax purposes, a debt becomes worthless when there is no longer any chance the amount owed will be paid. Therefore, a debt can be considered worthless even before it is due. In order to consider a debt worthless, you must show that you have taken reasonable steps to collect the debt.

How to Claim a Business Bad Debt. You can claim a business bad debt through either the specific charge-off method or the nonaccrual-experience method. Generally, you must use the specific charge-off method, although you may use the nonaccrual-experience method if you meet certain requirements.

Specific Charge-Off Method. Under the specific charge-off method, you can deduct specific business bad debts that become either partly or totally worthless during the tax year. For partially worthless debts, your tax deduction is limited to the amount you charge off on your books during the year. You can delay the charge off until a later year. However, you cannot deduct any part of a debt after the year it becomes totally worthless. For totally worthless debts, you can deduct the entire amount in the year it becomes worthless, less any amount deducted in an earlier tax year when the debt was only partially worthless.

Nonaccrual-Experience Method. Generally, you can use the nonaccrual-experience method for accounts receivable for services you performed only if you use an accrual method of account and meet either of the following two tests:

Service Related Income: The services were provided in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law or the performing arts. You cannot use the nonaccrual-experience method for amount owed to you from activities such as lending money, selling goods, or acquiring receivables or other rights to receive payment.

Gross Receipts Test: You are considered to have met the $5 million gross receipts test if your average annual gross receipts for any prior 3-tax-year period does not exceed $5,000,000.

Recovery of a Bad Debt. You may have to include in income any part of a bad debt that you claimed a deduction for on your income tax return but later recovered (collected). The amount you include is limited to the amount you actually deducted, although you can exclude the amount deducted that did not reduce your tax.

Your tax preparer can provide you with more information regarding business bad debts on your income tax return. StrataTax, a San Diego consulting and tax services firm, is available year-round to assist you with income tax preparation and tax planning. Call us at (858) 225-7720 to setup your free initial consultation or visit us atwww.StrataTax.com for more information.

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