Pub 535

A business bad debt is a loss from the worthlessness of a debt that was either:

1. Created or acquired in your trade or business, or
2. Closely related to your trade or business when it became partly or totally worthless.

The bad debts of a corporation are always business bad debts.

A debt is closely related to your trade or business if your primary motive for incurring the debt is a business reason.

Example. John Smith, an advertising agent, made loans to certain clients to retain their business. His main reason for
making these loans was to help his business. One of these clients later went bankrupt and could not repay him. Since
John's business was the main reason for making the loan, the debt was a business debt and he can take a business bad
debt deduction.

Debts from sales or services. Business bad debts are mainly the result of credit sales to customers. They can also be
the result of loans to suppliers, clients, employees, or distributors. Goods and services customers have not paid for are
shown in your books as either accounts receivable or notes receivable. If you are unable to collect any part of these
accounts or notes receivable, the uncollectible part is a business bad debt. Accounts or notes receivable valued at fair
market value at the time of the transaction are deductible only at that fair market value, even though the value may be
less than face value.

You can take a bad debt deduction for these accounts and notes receivable only if the amount owed you was included in
your gross income. This applies to amounts owed you from all sources of taxable income, such as sales, services, rents,
and interest.

If you qualify under certain rules, you can use the nonaccrual-experience method of accounting, discussed later. Under
this method, you do not have to accrue income that, based on your experience, you expect to be uncollectible.

Accrual method taxpayers. Accrual method taxpayers normally report income as they earn it. They can take a bad debt
deduction for uncollectible receivables if they have included the uncollectible amount in income.

Cash method taxpayers. Cash method taxpayers normally report income when they receive payment. They cannot take
a bad debt deduction for payments they have not received or cannot collect.

Debts from a former business. If you sell your business but keep its accounts receivable, these debts are business
debts since they arose in your trade or business. If an account becomes worthless, the loss is a business bad debt. These
accounts would also be business debts if sold to the new owner of the business.

If you sell your business to one person and sell your accounts receivable to someone else, the character of the debts as
business or nonbusiness is based on the activities of the holder of these debts. If the new holder engages in a trade or
business, a loss from these accounts is a business bad debt. If the new holder does not engage in a trade or business, a
loss from these accounts is a nonbusiness bad debt.

Debt acquired from a decedent. The character of a loss from a business acquired from a decedent is determined in the
same way as a debt sold by a business. If you are in a trade or business, the loss is a business bad debt. If you are not in
a trade or business, the loss is a nonbusiness bad debt.

Liquidation. If you liquidate your business and some of your accounts receivable become worthless, they are business
bad debts.

Debts of political parties. If a political party (or other organization that accepts contributions or spends money to
influence elections) owes you money and the debt becomes worthless, you cannot take a bad debt deduction unless you
use an accrual method of accounting and meet all the following tests:

1. The debt was from the sale of goods and services in the ordinary course of your trade or business
2. More than 30% of all your receivables accrued in the year of the sale were from sales made to political parties, and
3. You made substantial continuing efforts to collect on the debt.

Loan or capital contribution. You cannot take a bad debt deduction for a loan you made to a corporation if, based on
the facts and circumstances, the loan is actually a contribution to capital.

Debts of an insolvent partner. If your business partnership breaks up and one of your former partners is insolvent and
cannot pay any of the partnership's debts, you may have to pay more than your share of the partnership's debts. If you
pay any part of the insolvent partner's share of the debts, you can take a bad debt deduction.

Business loan guarantee. If you guarantee a debt that becomes worthless and can show the reason for guaranteeing it
was closely related to your trade or business, then the debt can qualify as a business bad debt. Consider any guarantee
you make to protect or improve your job as closely related to your trade or business as an employee.

Example. Bob Zayne owns the Zayne Dress Company. He guaranteed payment of a $20,000 note for Elegant Fashions,
a dress outlet. Elegant Fashions is one of Zayne's largest clients. Elegant Fashions later filed for bankruptcy and
defaulted on the loan. Mr. Zayne made full payment to the bank. He can take a business bad debt deduction, since his
guarantee was closely related to his trade or business. He was motivated by the desire to retain one of his better clients
and keep a sales outlet.

Deductible in the year paid. You can deduct a payment you make on a loan you guaranteed in the year of payment
unless you have rights against the borrower.

Rights against a borrower. When you make payment on a loan you guaranteed, you may have the right to take the place
of the lender. The debt is then owed to you. If you have this right, or some other right to demand payment from the
borrower, you cannot take a bad debt deduction until these rights become partly or totally worthless.

There are two ways to treat business bad debts: the specific charge-off and nonaccrual-experience methods. Most
taxpayers, except certain financial institutions, must use the specific charge-off method. However, certain taxpayers can
use the nonaccrual-experience method if they meet the requirements discussed later.

Recovery of bad debt. If you deduct a bad debt and later recover (collect) all or part of it, you may have to include all
or part of the recovery in gross income. The amount you include is limited to the amount you actually deducted. You can
exclude the amount deducted that did not reduce your tax.

Example. In 1996, the Willow Corporation had gross income of $158,000, a bad debt deduction of $3,500, and other
allowable deductions of $49,437. The corporation reported on the accrual method of accounting and used the specific
charge-off method for bad debts. The entire bad debt deduction reduced the tax on the 1996 corporate return. In 1997,
the corporation recovers part of the $3,500 deducted in 1996. It must include the part recovered in income for 1997.
For 1997, Willow reports the recovery as "Other income" on its corporate return.

Net operating loss (NOL) carryover. If a bad debt deduction increases an NOL carryover that has not expired before
the beginning of the tax year in which the recovery takes place, the deduction is treated as having reduced your tax.

Bankruptcy claim. You can deduct as a bad debt only the difference between the amount owed to you by a bankrupt
entity and the amount you received from the distribution of its assets.

Sale of mortgaged property. If you sell mortgaged or pledged property for less than the debt, the unpaid, uncollectible
balance of the debt after the sale is a bad debt. If the debt represents capital or an amount you previously included in
income, you can deduct it as a bad debt in the year it becomes totally worthless or in the year you charged it off as
partially worthless.

Net operating loss. A bad debt deduction may produce or increase a net operating loss. If you have a net operating loss
one year, you can carry it to other tax years and deduct it from income you earned in those years. As a result, a bad debt
deduction that contributes to a net operating loss helps lower taxes in the year to which you carry the net operating loss.

If you use the specific charge-off method, you can deduct specific business bad debts that become either partly or
totally worthless during the tax year.

Partly worthless debts. You can deduct specific bad debts that are partly uncollectible. Your deduction is limited to
the amount you charge off on your books during the tax year. You do not have to charge off and deduct your partly
worthless debts annually. You can delay the charge-off until a later year. You can wait until more of the debt becomes
worthless, or you have collected all you can and it is totally worthless. You cannot, however, deduct any part of a debt
after the year it becomes totally worthless.

Deduction disallowed. You can generally take a partial bad debt deduction only in the year you make the charge-off on
your books. If the Internal Revenue Service (IRS) does not allow your deduction and the debt becomes partly worthless
in a later tax year, you can deduct the amount you charge off in that year, plus the amount charged off in the earlier year.
The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year.

Totally worthless debts. Deduct a totally worthless debt only in the tax year it becomes totally worthless. You cannot
include any amount deducted in an earlier tax year when the debt was only partly worthless.

You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt.
However, you may want to do so. If you do not and the IRS later rules the debt is only partly worthless, you will not be
allowed a deduction for the debt in that tax year. A deduction of a partly worthless bad debt is limited to the amount
actually charged off.

Property received for debt. If you receive property in partial settlement of a debt, reduce the debt by the fair market
value of the property received. You can deduct the remaining debt as a bad debt in the year you determine it is
worthless and charge it off.

If you later sell the property, include any gain from the sale in gross income. The gain is a recovery of a bad debt you
deducted that reduced your tax.

If you use an accrual method of accounting and qualify under the rules explained in this section, you can use the
nonaccrual-experience method of accounting for bad debts. Under this method, you do not accrue income that you
expect to be uncollectible.

The nonaccrual-experience method applies only to amounts to be received (accounts receivable) for services you
performed. You cannot use it if you charge interest or penalties on late payments. If you determine, based on your
experience, that your accounts receivable are uncollectible, do not include them in your gross income for the tax year.

Performing services. You can use the nonaccrual-experience method only for amounts earned by performing services
that you would otherwise include in income. You cannot use this method for amounts owed to you from activities such
as lending money, selling goods, or acquiring receivables or other rights to receive payments.

Interest or penalty charged. Generally, you cannot use the nonaccrual-experience method for amounts due on which
you charge interest or a late payment penalty. However, do not treat a discount offered for early payment as interest or a
late payment penalty charged if:

1. You accrue the full amount due as gross income at the time you provide the services, and
2. You treat the discount allowed for early payment as an adjustment to gross income in the year of payment.

You can apply the nonaccrual-experience method under either a separate receivable system or a periodic system. Under
the separate receivable system, apply the nonaccrual-experience method separately to each account receivable. Under
the periodic system, apply the nonaccrual-experience method to total qualified accounts receivable at the end of your
tax year.

Treat each system as a separate method of accounting. You generally cannot change from one system to the other
without IRS approval.

Generally, you also need IRS approval to change to either system under the nonaccrual-experience method from a
different accounting method.