The answer, as is the answer with many tax questions, is maybe. Despite the recovering economy, almost every business will incur a bad debt. If it is a legitimate bad debt, the Internal Revenue Service (IRS) allows business taxpayers to deduct the entire bad debt in the year incurred. The business bad debt deduction arises from (2) possible scenarios.
1) A sale is made to a customer/client but the customer/client does not pay you and goes out of business.
2) A debt is incurred that is “closely related” or “proximate” to the business that becomes worthless.
Scenario 1, without being a tax professional, is very straight forward and understandable. To follow is an example: Company A sells 100 widgets for $100 to Company B. Company A recognizes (i.e. Pays tax) on the $100 sales income. Company B goes out of business cannot pay the $100 to Company A. Company A is clearly entitled to a $100 Business bad debt deduction in the year the debt becomes uncollectible.
Scenario 2 is where the advice of a tax professional might be required. The Internal Revenue Code states that a business may deduct any bad debt that is “proximate” or “closely related” to the business. In review of court cases, the key issue in determining if the debt is fully deductible is the “dominant motive”. To follow is a series of examples which demonstrate clearly deductible business bad debt, possibly deductible business bad debt, and almost certainly not deductible business bad debt:
Example 1: “Clearly Deductible Business Bad Debt”: A bank, which is in the business of making loans, loans $100,000 to a customer with the expectation of repayment of the $100,000 with a set rate of interest under specific written loan terms. If the customer is unable to repay the $100,000, the bank can deduct the $100,000 in full in the year incurred.
Example 2: “Not deductible business bad debt”: A 100% shareholder of a corporation withdraws $100,000 from the corporation. The purpose of the withdrawal was for the shareholder’s personal cash needs. The corporation is in the business of selling magazine subscriptions. It is not in the business of making loans. There are no specific loan repayment terms to the corporation. The shareholder, who has every intention to repay the $100,000, never actually pays the $100,000. The shareholder declares bankruptcy and cannot repay the $100,000 to the corporation. If the corporation deducted the $100,000 as business bad debt, it would almost certainly be disallowed under an audit. There was no business motive to make the loan to the shareholder. There were no set repayment terms with interest to the corporation. The likely result would be a disallowance of business bad debt deduction for the corporation. The corporation would be taxed on the $100,000 and penalized. Further, the shareholder would also be taxed on the $100,000 as ordinary compensation.
Example 3: “Possibly deductible business bad debt”: Corporation A, which is in the business of selling magazine subscriptions, loans $100,000 to Corporation B. Corporation B uses the $100,000 to pay its ordinary and necessary business expenses. Corporation B is also in the business of selling magazine subscriptions. Corporation A and Corporation B are both 100% owned by one person. Corporation B goes out of business and cannot repay Corporation A the $100,000 loan. The questions an auditor will most likely ask are: 1) was there a business motive for the loan? 2) Was debt incurred closely related to Corporation A? 3) Was there a valid creditor-debtor relationship? The answer to all three questions would be “maybe”. The auditor will ask for details of all transactions along with the “position” being taken to justify the deduction. A good accountant will be able represent the corporation and justify the “position” that the bad debt deduction is deductible.