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File 1040nrFile 1040nr 10. File 1040nr Business Bad Debts Table of Contents Introduction Topics - This chapter discusses: Useful Items - You may want to see: Definition of Business Bad DebtAccrual method. File 1040nr Cash method. File 1040nr Debt acquired from a decedent. File 1040nr Liquidation. File 1040nr Types of Business Bad Debts When a Debt Becomes Worthless How To Claim a Business Bad DebtSpecific Charge-Off Method Nonaccrual-Experience Method Recovery of a Bad DebtNet operating loss (NOL) carryover. File 1040nr Introduction You have a bad debt if you cannot collect money owed to you. File 1040nr A bad debt is either a business bad debt or a nonbusiness bad debt. File 1040nr This chapter discusses only business bad debts. File 1040nr Generally, a business bad debt is one that comes from operating your trade or business. File 1040nr You can deduct business bad debts on Schedule C (Form 1040) or your applicable business income tax return. File 1040nr All other bad debts are nonbusiness bad debts and are deductible only as short-term capital losses. File 1040nr For more information on nonbusiness bad debts, see Publication 550. File 1040nr Topics - This chapter discusses: Definition of business bad debt When a debt becomes worthless How to claim a business bad debt Recovery of a bad debt Useful Items - You may want to see: Publication 525 Taxable and Nontaxable Income 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts 544 Sales and Other Dispositions of Assets 550 Investment Income and Expenses 556 Examination of Returns, Appeal Rights, and Claims for Refund Form (and Instructions) Schedule C (Form 1040) Profit or Loss From Business 1040X Amended U. File 1040nr S. File 1040nr Individual Income Tax Return 1045 Application for Tentative Refund 1139 Corporation Application for Tentative Refund 3115 Application for Change in Accounting Method See chapter 12 for information about getting publications and forms. File 1040nr Definition of Business Bad Debt A business bad debt is a loss from the worthlessness of a debt that was either: Created or acquired in your trade or business, or Closely related to your trade or business when it became partly or totally worthless. File 1040nr A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. File 1040nr Bad debts of a corporation (other than an S corporation) are always business bad debts. File 1040nr Credit sales. File 1040nr Business bad debts are mainly the result of credit sales to customers. File 1040nr Goods that have been sold, but not yet paid for, and services that have been performed, but not yet paid for, are recorded in your books as either accounts receivable or notes receivable. File 1040nr After a reasonable period of time, if you have tried to collect the amount due, but are unable to do so, the uncollectible part becomes a business bad debt. File 1040nr Accounts or notes receivable valued at fair market value (FMV) when received are deductible only at that value, even though the FMV may be less than the face value. File 1040nr If you purchased an account receivable for less than its face value, and the receivable subsequently becomes worthless, the most you are allowed to deduct is the amount you paid to acquire it. File 1040nr You can claim a business bad debt deduction only if the amount owed to you was previously included in gross income. File 1040nr This applies to amounts owed to you from all sources of taxable income, including sales, services, rents, and interest. File 1040nr Accrual method. File 1040nr If you use the accrual method of accounting, you generally report income as you earn it. File 1040nr You can only claim a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income. File 1040nr If you qualify, you can use the nonaccrual-experience method of accounting discussed later. File 1040nr Under this method, you do not have to accrue income that, based on your experience, you do not expect to collect. File 1040nr Cash method. File 1040nr If you use the cash method of accounting, you generally report income when you receive payment. File 1040nr You cannot claim a bad debt deduction for amounts owed to you because you never included those amounts in income. File 1040nr For example, a cash basis architect cannot claim a bad debt deduction if a client fails to pay the bill because the architect's fee was never included in income. File 1040nr Debts from a former business. File 1040nr If you sell your business but retain its receivables, these debts are business debts because they arose out of your trade or business. File 1040nr If any of these receivables subsequently become worthless, the loss is still a business bad debt. File 1040nr Debt acquired from a decedent. File 1040nr The character of a loss from debts of a business acquired from a decedent is determined in the same way as debts acquired on the purchase of a business. File 1040nr The executor of the decedent's estate treats any loss from the debts as a business bad debt if the debts were closely related to the decedent's trade or business when they became worthless. File 1040nr Otherwise, a loss from these debts becomes a nonbusiness bad debt for the decedent's estate. File 1040nr Liquidation. File 1040nr If you liquidate your business and some of the accounts receivable that you retain become worthless, they become business bad debts. File 1040nr Types of Business Bad Debts Business bad debts may result from the following. File 1040nr Loans to clients and suppliers. File 1040nr If you loan money to a client, supplier, employee, or distributor for a business reason and you are unable to collect the loan after attempting to do so, you have a business bad debt. File 1040nr Debts owed by political parties. File 1040nr 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 can claim a bad debt deduction only if all of the following requirements are met. File 1040nr You use the accrual method of accounting. File 1040nr The debt arose from the sale of goods or services in the ordinary course of your trade or business. File 1040nr More than 30% of your receivables accrued in the year of the sale were from sales to political parties. File 1040nr You made substantial and continuing efforts to collect on the debt. File 1040nr Loan or capital contribution. File 1040nr You cannot claim 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. File 1040nr Debts of an insolvent partner. File 1040nr If your business partnership breaks up and one of your former partners becomes insolvent, you may have to pay more than your pro rata share of the partnership's debts. File 1040nr If you pay any part of the insolvent partner's share of the debts, you can claim a bad debt deduction for the amount you paid that is attributable to the insolvent partner's share. File 1040nr Business loan guarantee. File 1040nr If you guarantee a debt that subsequently becomes worthless, the debt can qualify as a business bad debt if all the following requirements are met. File 1040nr You made the guarantee in the course of your trade or business. File 1040nr You have a legal duty to pay the debt. File 1040nr You made the guarantee before the debt became worthless. File 1040nr You meet this requirement if you reasonably expected you would not have to pay the debt without full reimbursement from the borrower. File 1040nr You received reasonable consideration for making the guarantee. File 1040nr You meet this requirement if you made the guarantee in accord with normal business practice or for a good faith business purpose. File 1040nr Example. File 1040nr Jane Zayne owns the Zayne Dress Company. File 1040nr She guaranteed payment of a $20,000 note for Elegant Fashions, a dress outlet. File 1040nr Elegant Fashions is one of Zayne's largest clients. File 1040nr Elegant Fashions later defaulted on the loan. File 1040nr As a result, Ms. File 1040nr Zayne paid the remaining balance of the loan in full to the bank. File 1040nr She can claim a business bad debt deduction only for the amount she paid, since her guarantee was made in the course of her trade or business for a good faith business purpose. File 1040nr She was motivated by the desire to retain one of her better clients and keep a sales outlet. File 1040nr Deductible in the year paid. File 1040nr If you make a payment on a loan you guaranteed, you can deduct it in the year paid, unless you have rights against the borrower. File 1040nr Rights against a borrower. File 1040nr When you make payment on a loan you guaranteed, you may have the right to take the place of the lender. File 1040nr The debt is then owed to you. File 1040nr If you have this right, or some other right to demand payment from the borrower, you cannot claim a bad debt deduction until these rights become partly or totally worthless. File 1040nr Joint debtor. File 1040nr If two or more debtors jointly owe you money, your inability to collect from one does not enable you to deduct a proportionate amount as a bad debt. File 1040nr Sale of mortgaged property. File 1040nr If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt. File 1040nr When a Debt Becomes Worthless A debt becomes worthless when there is no longer any chance the amount owed will be paid. File 1040nr This may occur when the debt is due or prior to that date. File 1040nr To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. File 1040nr It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. File 1040nr Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt. File 1040nr Property received for debt. File 1040nr If you receive property in partial settlement of a debt, reduce the debt by the property's FMV, which becomes the property's basis. File 1040nr You can deduct the remaining debt as a bad debt if and when it becomes worthless. File 1040nr If you later sell the property for more than its basis, any gain on the sale is due to the appreciation of the property. File 1040nr It is not a recovery of a bad debt. File 1040nr For information on the sale of an asset, see Publication 544. File 1040nr How To Claim a Business Bad Debt There are two methods to claim a business bad debt. File 1040nr The specific charge-off method. File 1040nr The nonaccrual-experience method. File 1040nr Generally, you must use the specific charge-off method. File 1040nr However, you may use the nonaccrual-experience method if you meet the requirements discussed later under Nonaccrual-Experience Method . File 1040nr Specific Charge-Off Method 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. File 1040nr However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the year. File 1040nr Partly worthless debts. File 1040nr You can deduct specific bad debts that become partly uncollectible during the tax year. File 1040nr Your tax deduction is limited to the amount you charge off on your books during the year. File 1040nr You do not have to charge off and deduct your partly worthless debts annually. File 1040nr You can delay the charge off until a later year. File 1040nr However, you cannot deduct any part of a debt after the year it becomes totally worthless. File 1040nr Significantly modified debt. File 1040nr An exception to the charge-off rule exists for debt which has been significantly modified and on which the holder recognized gain. File 1040nr For more information, see Regulations section 1. File 1040nr 166-3(a)(3). File 1040nr Deduction disallowed. File 1040nr Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. File 1040nr If, under audit, the IRS does not allow your deduction and the debt becomes partly worthless in a later tax year, you can deduct the amount you charged off in that year plus the disallowed amount charged off in the earlier year. File 1040nr The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year. File 1040nr Totally worthless debts. File 1040nr If a debt becomes totally worthless in the current tax year, you can deduct the entire amount, less any amount deducted in an earlier tax year when the debt was only partly worthless. File 1040nr You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. File 1040nr However, you may want to do so. File 1040nr 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 because a deduction of a partly worthless bad debt is limited to the amount actually charged off. File 1040nr See Partly worthless debts, earlier. File 1040nr Filing a claim for refund. File 1040nr If you did not deduct a bad debt on your original return for the year it became worthless, you can file a claim for a credit or refund. File 1040nr If the bad debt was totally worthless, you must file the claim by the later of the following dates. File 1040nr 7 years from the date your original return was due (not including extensions). File 1040nr 2 years from the date you paid the tax. File 1040nr If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates. File 1040nr 3 years from the date you filed your original return. File 1040nr 2 years from the date you paid the tax. File 1040nr You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. File 1040nr Such an impairment requires proof of existence. File 1040nr For details and more information about filing a claim, see Publication 556. File 1040nr Use one of the following forms to file a claim. File 1040nr For more information, see the instructions for the applicable form. File 1040nr Table 10-1. File 1040nr Forms Used To File a Claim IF you filed as a. File 1040nr . File 1040nr . File 1040nr THEN file. File 1040nr . File 1040nr . File 1040nr Sole proprietor or farmer Form 1040X Corporation Form 1120X S corporation Form 1120S and check box H(4) Partnership Form 1065X if filing on paper or Form 1065 and check box G(5) if filing electronically Nonaccrual-Experience Method If you use an accrual method of accounting and qualify under the rules explained in this section, you can use the nonaccrual-experience method for bad debts. File 1040nr Under this method, you do not accrue service related income you expect to be uncollectible. File 1040nr Because the expected uncollectible amounts are not included in income, these amounts are not later deducted from income. File 1040nr Generally, you can use the nonaccrual-experience method for accounts receivable for services you performed only if: The services are provided in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, or the performing arts, or You meet the $5 million gross receipts test for all prior years. File 1040nr Service related income. File 1040nr You can use the nonaccrual-experience method only for amounts earned by performing services. File 1040nr 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 payment. File 1040nr Gross receipts test. File 1040nr To find out if you meet the $5 million gross receipts test for all prior years, you must figure the average annual gross receipts for each prior year. File 1040nr If your average annual gross receipts for any year exceeds $5 million, you cannot use the non-accural experience method. File 1040nr The average annual gross receipts for any year is the average of gross receipts from the year in question and the 2 previous years. File 1040nr For example, if you were figuring the average annual gross receipts for 2013, you would average your gross receipts for 2011, 2012, and 2013. File 1040nr Interest or penalty charged. File 1040nr Generally, you cannot use the nonaccrual-experience method for amounts due on which you charge interest or a late payment penalty. File 1040nr However, do not treat a discount offered for early payment as the charging of interest or a penalty if both the following apply. File 1040nr You otherwise accrue the full amount due as gross income at the time you provide the services. File 1040nr You treat the discount allowed for early payment as an adjustment to gross income in the year of payment. File 1040nr Change in accounting method. File 1040nr Generally, you must obtain consent to change to a nonaccrual-experience method (other than one of the safe harbor methods) or to change from one method to another. File 1040nr See Form 3115 and the Instructions for Form 3115 for more information. File 1040nr Recovery of a Bad Debt If you claim a deduction for a bad debt on your income tax return and later recover (collect) all or part of it, you may have to include all or part of the recovery in gross income. File 1040nr The amount you include is limited to the amount you actually deducted. File 1040nr However, you can exclude the amount deducted that did not reduce your tax. File 1040nr Report the recovery as “Other income” on the appropriate business form or schedule. File 1040nr See Recoveries in Publication 525 for more information. File 1040nr Net operating loss (NOL) carryover. File 1040nr 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, you treat the deduction as having reduced your tax. File 1040nr A bad debt deduction that contributes to a NOL helps lower taxes in the year to which you carry the NOL. File 1040nr For more information about NOLs, see Publication 536. File 1040nr Also, see the Instructions for Form 1045, and the Instructions for Form 1139. File 1040nr Prev Up Next Home More Online Publications
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