Businesses can claim a bad debt deduction under the Internal Revenue Code when a customer fails to pay for services or products. However, the ability to claim this deduction depends on several factors, and businesses should be prepared to substantiate their claim if challenged by the IRS.

The key issues discussed include the requirement of a debtor-creditor relationship, the type of debt, the basis for the debt, and the timing of the deduction. For instance, the deduction only applies to business bad debts not treated as a security for federal income tax purposes. The amount used to determine the bad debt deduction is the adjusted tax basis in the debt, not the debt’s face value. Moreover, the deduction must be taken in the year the debt becomes worthless or partially worthless.

The article also highlights the importance of including the debt in taxable income if it arose from unpaid wages, salaries, fees, or similar items. If these amounts have not been included in taxable income, a bad debt deduction is not eligible. Furthermore, if a business recovers a debt previously claimed as worthless and took a bad debt deduction against, the recovery amount must be included in gross income, but only to the extent that a previous deduction created a tax benefit.

In conclusion, when a debt becomes uncollectible, it’s crucial to understand the requirements for claiming an ordinary deduction with respect to the write-off of that debt. Continuous evaluation of the worthlessness of debt when there is a risk of nonpayment is important, as is documenting the facts expected to trigger full or partial worthlessness in case of an IRS challenge. Read the full article here.