If a business owner lends money to an individual and that person cannot repay the loan, what happens? The business may be able to win a settlement in court, but legal fees will weigh heavily on the funds recovered. For debts of $ 10,000 or less, small claims court may be the only option, but it is also stressful and time consuming.
For many business owners, it is possible to get a bad debt deduction on their taxes in order to recover some of what has been lost. This can be the most efficient and inexpensive way to recover at least part of the outstanding balance.
What is bad debt?
Generally speaking, a bad debt is a loan that was made with the intention of being repaid but is now bad debt.
There is also an essential distinction between commercial and non-commercial debt. According to the IRS, trade debts come from operating your business, while non-business bad debts are debts where the primary reason for incurring the debt was not related to the business.
The following are examples of IRS bad debts:
- Loans that your business gives to customers, distributors, employees or suppliers
- Sales to customers on credit
- Business loan guarantees
For example, a business owner may decide to lend money to a client who is growing their business in a way that will benefit both parties financially. In order for this loan to later be considered bad debt, both entities must have a contract that explains how the money will be repaid over time, as well as the interest and fees they will pay along the way. If the customer later closes their business, that loan may become bad debt because the customer has no way to repay the loan.
Specifically, the IRS says that the worthless debt you claim must be “created or acquired in a trade or business or closely related to your trade or business when it has become partly or wholly worthless.”
An example of non-commercial debt is lending money from your personal bank account to a friend, who promises in writing to pay you back. If that friend declares bankruptcy and can no longer reasonably pay you back, you now have a bad debt.
Before you can deduct a bad debt, however, that debt must be worthless. In other words, the debtor must have stopped paying completely, and you must have good reason to believe that they will never pay you back.
The debtor’s bankruptcy filing is an example of strong evidence that a debt is worthless, but you can also go ahead with a bad debt if the person has made no effort to repay their loan and if they don’t. do not respond to inquiries or send you a message. send them about their debt.
You must also be able and willing to prove that the loan was not a gift. According to the IRS, “If you lend money to a relative or friend with the understanding that the relative or friend may not repay it, you should treat it as a gift and not a loan, and you cannot deduct it as a bad debt. . “
Methods for writing off bad debts
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If repeated efforts to collect a debt have failed, it is possible to write off that debt. There are a few ways to do this.
Direct radiation method
Once a particular debt has been identified as bad, it is possible to write off the debt by charging it. This approach, known as the direct write-off method, involves debiting a business bad debt account and crediting an account receivable with the amount of bad money the business has.
Using the direct write-off method does not reduce the number of sales recorded for a business, but it does increase bad debt expense.
In addition, the direct depreciation method violates what is known as the “matching principle”, which requires that all costs related to the company’s income be charged to expenses at the same time as the company records. initially income. The objective of the matching principle is that companies report all income-generating transactions during the same accounting period.
The allowance method is simply to recognize that a certain percentage of accounts receivable simply will not be collectible. In other words, a business may have a history of not being able to collect around 5% of its accounts receivable. Based on this precedent, a business can reasonably create an allowance for bad debts for 5% of current accounts receivable.
“When the allowance for bad debt is calculated, lenders estimate the percentage of sales that could become bad debt. This expected bad debt amount is then deducted from lenders’ income during each accounting period,” says Katie Bossler, of GreenPath Financial Wellness. “The allowance for bad debt can be viewed as an estimate of the amount of money that cannot be collected.”
How to file a bad debt deduction
Before going ahead with a bad debt tax deduction, the IRS would like to see proof of collection efforts, such as any certified letter you sent requesting reimbursement. An email exchange could also serve as evidence to support your claim.
For bad debts from a business, you will report your bad debts on Schedule C of your tax forms. For non-business bad debt, you must complete Form 8949. You can use the loss to offset any capital gain you realized in the year the debt became worthless. If your loss exceeds your gain, you get the standard $ 3,000 deduction on income other than a capital gain. Any unused loss is reported in short-term depreciation.
When to consider deducting a debt
Christian Brim, CEO of Core Business and Financial Services, says that given the variables involved in determining whether an expense qualifies for bad debt taxes, you have some flexibility in your timing. For example, you may not feel ready to consider a debt “completely worthless” until you wait long enough to be absolutely certain that you will never be paid off.
“Assuming you can deduct debt in any given year, it may make sense to delay or speed up bad debt deductions as part of your overall tax planning strategy,” Brim explains.
You may want to sync your bad debt tax deduction based on your anticipated income and expenses, as well as tax rates. Brim also notes that filing an extension can save you time to see a substantial amount of the next tax year before you have to make a decision.
The bottom line
There are a variety of ways to deal with bad loans or bad debts, including writing off these items and deducting them from taxes. Before taking any of these steps, however, it is important to attempt to collect the debt and document all your efforts.