Bad Debts - Comprehensive Notes (Assignment 13)

¶1301 Introduction

• A bad debt deduction may be claimed when a money loaned to a taxpayer becomes uncollectible.
• Eligibility criteria for a bad debt deduction:
  • The debt must be valid, legally enforceable, and in a fixed amount.
  • Valid debt: based on a bona fide and enforceable duty of repayment (e.g., a signed contract).
  • Legally enforceable: the debt must still be collectible under the law (e.g., not barred by statute of limitations; not tied to illegal activities).
  • Example of invalid debt: a gambling debt cannot be enforced in most states and will not qualify for a bad debt deduction.
  • The amount of the debt (including interest or late fees) must be fixed.
• Special consideration when the debt involves a relative:
  • Courts presume loans to a taxpayer’s children are gifts unless there is convincing evidence of a definite expectation of repayment.
  • If circumstances indicate a definite expectation of repayment, the deduction is permitted; otherwise, it may be denied as a gift.
• Example illustrating family loan issue (son-in-law):
  • Taxpayer loaned money to his son-in-law to start a new business, with no investigation of the venture and no means to secure the debt; the venture fails and the son-in-law cannot repay.
  • No bad debt deduction because it did not appear that the taxpayer seriously expected repayment.
• Key Takeaways:
  • If a debt is valid, legally enforceable, fixed, and becomes uncollectible, a bad debt deduction may be claimed.
  • There is a presumption that loans to a taxpayer’s children are gifts unless evidence shows otherwise.

¶1302 Debt Must Be Worthless

• A debt must be uncollectible now or in the future to be charged off as a bad debt.
• The taxpayer must show reasonable steps to collect the debt unless there is clear evidence that recovery is unlikely.
• Generally sufficient evidence of worthlessness includes debtor bankruptcy or disappearance.
• Legal action to collect is not necessary if a judgment would be worthless.
• If the taxpayer endorsed or guaranteed someone else’s loan and must pay on behalf of the borrower, a bad debt deduction may be taken if collection from the borrower fails and the guarantee/endoresement was made with either:
  • a profit motive, or
  • it was related to the taxpayer’s trade, business, or employment.
• Example: Jones invested in a merchandising corporation; the company later falters and a major supplier demands payment unless Jones personally guarantees it. When the corporation cannot pay, Jones pays and cannot recover from the corporation; a bad debt deduction may be allowed because the guarantee was to protect his investment.
• Debts owed by political parties are generally not deductible (treated as campaign contributions).
• Taxpayers on different bases have different rules:
  • Cash basis: must have loaned out or previously included the amount in income to claim the deduction; cannot claim a bad debt deduction for uncollected wages, interest, rents, fees, or merchandise sold if those amounts were not reported as income.
  • Accrual basis: if amounts were reported as income when due, may claim the bad debt when it becomes uncollectible.
• Summary: A debt must be worthless and properly supported by collection efforts and the basis of the debt method (cash vs accrual) to qualify for the deduction.

¶1303 Amount of Deduction

• The deduction amount is equal to the basis the debt would have had if it were sold at a loss, not necessarily the face amount of the debt.
• Example:
  • A sells $5{,}000 worth of merchandise to B and receives B’s note in return.
  • A then sells the note to C for $4{,}500.
  • B becomes bankrupt and the note becomes totally worthless.
  • C’s bad debt deduction is $4{,}500, the amount paid for the note.
• The method of deducting a bad debt depends on whether the debt is a business bad debt or a nonbusiness bad debt.
• Key Takeaway:
  • The deduction is based on the debt’s basis as if sold at a loss; it is not necessarily the face amount.
  • The nature of the debt (business vs nonbusiness) also affects treatment.

¶1304 Business Bad Debts

• A business bad debt is fully deductible, treated like an ordinary business expense.
• Deduction is allowed if the debt becomes completely worthless, or if it is partially worthless with the unrecovered portion determinable with reasonable certainty.
• Example: Mr. Hamilton, a jeweler on an accrual basis, sells a $2{,}000 bracelet on credit; the customer declares bankruptcy and it is reasonably certain he will recover no more than 50% of the amount owed. He may charge off and deduct $1{,}000.
• Business bad debts are deducted on Schedule C (or Schedule F for farming).
• Key Takeaways:
  • Business bad debts are treated as ordinary business expenses and are fully deductible up to the portion not collectible.
  • Business bad debts are deducted on Schedules C or F.

¶1305 Nonbusiness Bad Debts

• Nonbusiness bad debts are those not originated or acquired in the taxpayer’s trade or business, and are treated as short-term capital losses.
• This includes debts arising from profit-motivated transactions as well as purely personal debts (e.g., loans to friends or relatives) that are not gifts.
• In the ¶1302 example, Jones would have a nonbusiness bad debt deduction unless he was employed by the corporation or the corporation was his actual trade or business.
• Because nonbusiness bad debts are treated as short-term capital losses, they are subject to capital loss limitations and must be reported on Schedule D and Form 8949, together with any other capital gains and losses.
• Reporting on Form 8949 is covered in IRS Topic No. 453 Bad Debt Deduction.
• Each nonbusiness bad debt requires a detailed entry on the return, including:
  • a description of the debt, the amount, and the due date;
  • the name of the debtor and any business or family relationship to the debtor;
  • the efforts made to collect the debt;
  • the reason why the debt is worthless.
• Important rule: No deduction may be taken for a nonbusiness bad debt that becomes only partially worthless. If part of a debt is paid and the remainder is entirely uncollectible, the remaining balance is deemed wholly worthless and deductible.
• Examples:
  • Example (1): Taxpayer lends $1{,}000 to a friend who dies; creditors receive 25 cents on the dollar. The taxpayer cannot claim a deduction for the worthless portion until after receiving payment of the collectible part.
  • Example (2): A wholesaler on open credit to B; business is sold but credit claim remains; in 2024 the claim becomes worthless. It is a business bad debt because it was acquired in the course of A’s business.
  • Example (3): If the same facts as Example (2) but the claim is sold to C (not the original buyer) in 2023, C is entitled to a nonbusiness bad debt deduction in 2024.
  • Example (4): An employee lending money to the employer to keep the company afloat; if the company cannot repay and the debt becomes uncollectible, it is a business bad debt. If the relationship is only incidental, it is a nonbusiness bad debt.
• Key Takeaways:
  • Nonbusiness bad debts are short-term capital losses.
  • They are subject to capital loss limitations and reported on Schedule D and Form 8949; deductible regardless of whether the taxpayer itemizes.
  • No deduction for a nonbusiness debt that is only partially worthless; partial payments yield the remainder as fully worthless later.

¶1306 When Deductible

• Nonbusiness bad debts must be deducted in the year they become worthless.
• If a later year reveals the debt was worthless in an earlier year, file an amended return for the year the debt became worthless and claim a refund.
• Refund claims for bad debts or worthless securities may be filed up to seven years after the due date of the original return (instead of the standard three years).
• Example: In 2016, taxpayer loans money overseas; sporadic payments occur; after several years, debtor’s mental illness is established (since 2018) and no prospect of recovery exists.
  • The taxpayer should file an amended return for 2018 and claim a refund for that year. The return may be filed any time up to April 15, 2026 (seven years from the due date of the 2018 return).
• Completely worthless business bad debts must be deducted in the year they become worthless; partially worthless business bad debts may be deducted in that year or deferred until the debt becomes completely worthless.
• When claiming a bad debt deduction, attach a statement to the return with:
  1. The nature of the debt;
  2. The debtor’s name and any business or family relationship to the taxpayer;
  3. When the debt came due;
  4. The efforts made to collect the debt; and
  5. How the debt was determined to be worthless.
• Key Takeaways:
  • Nonbusiness bad debts must be deducted in the year they become worthless; amend returns if later evidence arises.
  • Amended returns for bad debt claims may be filed up to seven years after the due date of the original return.
  • Completely worthless business bad debts must be deducted in the year they become worthless; partially worthless business bad debts may be deducted in the year the debt becomes completely worthless.

¶1307 Loss on Deposits in Insolvent Financial Institutions

• If a taxpayer loses all or part of a deposit in a bank, savings & loan, or other financial institution that becomes insolvent or bankrupt, there are three treatment options:
  1) Nonbusiness bad debt;
  2) Casualty loss; or
  3) Ordinary loss treatment (available under 1987 amendments).
• If the deposit is not related to the taxpayer’s trade or business, treating as a bad debt may incur the capital loss limitations; treating as a casualty loss uses casualty loss limitations; historic law allowed a third option of ordinary loss that is fully deductible against other income to the extent the loss exceeds 2% of AGI.
• Under the TCJA (2018-2025): you can no longer claim miscellaneous itemized deductions, including the ordinary loss deduction for deposits in insolvent financial institutions.
• The loss-on-deposits election is available only if no part of the deposit is federally insured, with a yearly maximum deduction of $20,000 ($10,000 for married filing separately), less any expected state insurance proceeds. The limit applies per institution, and the election must be made on the return for the year in which the loss occurs or can be reasonably estimated. Once made, the election cannot be revoked without IRS consent.
• Key Takeaways:
  • A loss from a deposit can be treated as a nonbusiness bad debt or casualty loss.
  • Prior to TCJA, there was a third option to treat as an ordinary loss.
  • When the loss-on-deposits election was available, it required that the deposit be not federally insured and the yearly maximum deduction was $20,000 per institution (less insurance proceeds).

¶1308 Recovery of Bad Debts

• If a deduction for a bad debt is later recovered (in whole or in part), the recovery generally must be included in gross income in the year received.
• The recovery is not reportable or taxable if the original deduction did not result in a tax reduction.
• Example: In 2018, Mr. O’Connor claimed a bad debt deduction of $800. His 2018 AGI was $20,000, with five exemptions and $9,000 in itemized deductions. In 2024, he recovered $500. Because O’Connor would have paid no tax in 2018 even without the bad debt deduction, he need not report the recovery in 2024.
• Key Takeaways:
  • If a bad debt deduction is later recovered, include the recovery in gross income in the year received.
  • If the original deduction did not reduce tax, the recovery is not subject to tax or reporting.