Attempts to claim write-offs for bad debt losses have fueled controversies with the IRS for many years. Unfortunately, bad debt losses are increasingly common during the COVID-19 pandemic. Here's an overview of the federal income tax treatment of these losses. 

The Basics

The IRS is always skeptical when taxpayers claim deductions for bad debt losses. Why? Losses related to purported loan transactions are often from some other type of nondeductible deal that failed.

For example, you might make a contribution to the capital of a business entity that closed. Or you might advance cash to a friend or relative with the unrealistic hope that the money would be paid back and you and the other party never put anything in writing.

To claim a deductible bad debt loss that will survive IRS scrutiny, you or your business must first be prepared to prove that the loss was from a soured loan transaction, instead of from some other ill-fated financial move.

Rules for Individual Taxpayers

Assuming you can establish that you made a legitimate loan that has now gone bad, the next question is: Do you have a business bad debt loss or a non-business bad debt loss? The answer determines the appropriate federal income tax treatment for the loss.

Business bad debt losses. Losses from bad debts that arise in the course of an individual taxpayer's business activity are generally treated as ordinary losses. Ordinary losses are usually fully deductible without any limitations. In addition, partial worthlessness deductions can be claimed for business debts that go partially bad.

However, there's an important exception when a taxpayer makes an ill-fated loan to his or her employer that results in a business bad debt loss. Because the taxpayer is in the business of being an employee of the company, the IRS says the write-off should be treated as an unreimbursed employee business expense.

Before the Tax Cuts and Jobs Act (TCJA), you could deduct unreimbursed employee business expenses, along with certain other miscellaneous expenses, to the extent the total exceeded 2% of your adjusted gross income (AGI). However, the TCJA suspended these deductions for 2018 through 2025.

Non-business bad debt losses. An individual's bad debt losses that don't arise in the course of the individual's business are treated as short-term capital losses. As such, they're subject to the capital loss deduction limitations.

Specifically, you can usually deduct up to $3,000 of capital losses each year ($1,500 per year if you use married filing separate status) even if you have no capital gains. Additional capital losses can only be deducted against capital gains from other sources. Any excess net capital loss can be carried forward indefinitely. So, if you have a large non-business bad debt loss and capital gains that amount to little or nothing, it can take years to fully deduct the bad debt loss. In addition, losses can't be claimed for partially worthless non-business bad debts.

Rules for Business Taxpayers

The amount of a business's bad debt loss deduction for a completely worthless debt equals the adjusted tax basis of the debt for purposes of determining a loss. The adjusted basis generally equals:

• The face amount,

• The outstanding debt balance if principal payments have been received, or

• For trade notes or payables, the amount previously recognized as taxable income.

If property is received in partial settlement of a debt, the basis of the debt is reduced by the fair market value of the property received.

The federal income tax treatment of the loss varies as follows, based on the business's accounting method:

Cash-basis business taxpayers. Business entities that use the cash method of accounting for tax purposes can't deduct bad debts arising from the failure to be paid for services rendered, because income from the services hasn't been recognized for tax purposes in the tax year when worthlessness is established or an earlier year. Therefore, the debt has no tax basis, and no deduction is allowed for the loss. The same treatment applies to bad debts from unpaid fees, unpaid rents or similar items that haven't been recognized as taxable income in the tax year when worthlessness is established or an earlier year.

For example, Company A uses the cash method of accounting for tax purposes. In Year 1, Company A bills a client $50,000 for services rendered, but the client never pays the bill. In Year 2, it becomes clear that all collection efforts have failed. However, Company A can't claim a bad debt deduction for the $50,000 loss, because that amount was never included in the corporation's taxable income. The debt had no tax basis, so no deduction is allowed.

Accrual-basis business taxpayers. Business entities that use the accrual method of accounting for tax purposes can generally deduct a bad debt loss in the year when worthlessness is established.

For example, Company B uses the accrual method of accounting for tax purposes. In Year 1, Company B bills a customer $100,000 for services and reports that amount as taxable income on its Year 1 federal income tax return. By the end of Year 2, all efforts to collect the $100,000 receivable have failed. Company B can claim a $100,000 bad debt deduction in Year 2.

Partially Worthless Business Debts

Assuming the debt in question is a business debt that has tax basis, a portion of the basis can be deducted in the year when the debt becomes partially worthless. However, the taxpayer must show that partial worthlessness has occurred, and it must disclose the amount that has been charged off on its books. The requirement to record a book charge-off apparently means the portion charged off must no longer appear as an asset on the taxpayer's books.

The taxpayer isn't required to claim a deduction in the tax year when a debt becomes partially worthless. The taxpayer can deduct nothing, all or any part of the amount of the debt that's charged off on the books in that year. Alternatively, the taxpayer can deduct the entire debt in the tax year when it becomes wholly worthless.

Extended Statute of Limitations

It's sometimes difficult to prove that a debt became worthless in a particular tax year. In the event of an audit, the IRS may take the position that worthlessness occurred in a year earlier than the year in which the bad debt deduction was claimed. To protect taxpayers from losing righteous bad debt deductions because the statute of limitations for amending returns has expired, a special tax code provision extends the statute of limitations for claiming bad debt deductions from the standard three years to seven years.

If any doubt exists about the proper tax year in which to claim a bad debt deduction, it's good policy to claim the deduction in the earliest year it could possibly be allowed. If it later becomes clear that the deduction should have been claimed in a later year, an amended return can be filed for the earlier year.

When Debts Go Bad

With good professional advice and advance planning, bad debts from legitimate lending transactions can be treated as such for federal income tax purposes. In contrast, without adequate attention to the relevant details, the IRS can claim that your purported lending transaction was something else — such as a gift to an individual or a contribution to the capital of a business — which could create unfavorable tax results. Contact your tax advisor if you have questions or want more information.