Fall Back on Bad Debt Deductions

If you are an accrual-based taxpayer and your customers don't pay their bills, Uncle Sam provides a last resort for business owners: You can deduct a bad business debt in the year it becomes worthless — if you've tried everything to collect.

In order to get the write-off, you have to prove that the debt will not be paid. If you're lucky, there is a significant event that demonstrates a debt's worthlessness, such as the debtor's death or declaration of bankruptcy. Otherwise, your company has the responsibility for proving the worthlessness of the debt.

The IRS often challenges the timing of bad debt deductions, so it's important to build a solid case. Here are a few tips:

• Document all the efforts you make to collect amounts owed by a debtor, including records of telephone calls, dunning letters and email communication.
• Be persistent. Don't just send one letter and let it go at that.
• Pursue bad debts quickly to ascertain whether recovery is possible. That's because a bad debt deduction must generally be claimed on the tax return for the year it was sustained. You may not be able to take a loss in a later year.

Business or Personal?

Under the tax code, business bad debts are more advantageous than personal bad debts. In addition to claiming a full deduction for a business-related loan that goes bad:

1. You can write off the full amount against ordinary income (rather than as a short-term capital loss that may be limited to $3,000 per year).
2. You can deduct a partial loss for a business bad debt. Personal debts can be deducted only if they are entirely worthless.

Bad debt bonus: The statute of limitations for bad debts is longer than the usual three-year time limit for most items on your tax return. In general, you can amend your tax return to claim a bad debt for seven years from the due date of the tax return for the year that the debt became worthless. For more information, talk with your tax advisor.