Page 101 - Small Business Taxes

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1120-X 1120-X Amended U.S. Corporation Debts from a former business. If you sell debt can qualify as a business bad debt if all of
Income Tax Return your business but retain its receivables, these the following requirements are met.
1139 1139 Corporation Application for debts are business debts because they arose • You made the guarantee in the course of
your trade or business.
Tentative Refund out of your trade or business. If any of these re- • You have a legal duty to pay the debt.
ceivables subsequently become worthless, the
3115 3115 Application for Change in loss is still a business bad debt. • You made the guarantee before the debt
Accounting Method became worthless. You meet this require-
Debt acquired from a decedent. The
See chapter 12 for information about getting character of a loss from debts of a business ac- ment if you reasonably expected you
publications and forms. quired from a decedent is determined in the wouldn’t have to pay the debt without full
reimbursement from the borrower.
same way as debts acquired on the purchase of • You received reasonable consideration for
Definition of Business a business. The executor of the decedent's es- making the guarantee. You meet this re-
tate treats any loss from the debts as a busi-
Bad Debt ness bad debt if the debts were closely related quirement if you made the guarantee ac-
cording to normal business practice or for
to the decedent's trade or business when they a good faith business purpose.
A business bad debt is a loss from the worth- became worthless. Otherwise, a loss from
these debts becomes a nonbusiness bad debt
lessness of a debt that was either: for the decedent's estate. Example. Jane Zayne owns the Zayne
• Created or acquired in your trade or busi- Dress Company. She guaranteed payment of a
ness, or Liquidation. If you liquidate your business $20,000 note for Elegant Fashions, a dress out-
• Closely related to your trade or business and some of the accounts receivable that you let. Elegant Fashions is one of Zayne's largest
when it became partly or totally worthless. retain become worthless, they’re treated as clients. Elegant Fashions later defaulted on the
A debt is closely related to your trade or business bad debts. loan. As a result, Ms. Zayne paid the remaining
balance of the loan in full to the bank.
business if your primary motive for incurring the She can claim a business bad debt deduc-
debt is business related. Bad debts of a corpo- Types of Business Bad tion only for the amount she paid because her
ration (other than an S corporation) are always Debts guarantee was made in the course of her trade
business bad debts. or business for a good faith business purpose.
Business bad debts may result from the follow- She was motivated by the desire to retain one
Credit sales. Business bad debts are mainly ing. of her better clients and keep a sales outlet.
the result of credit sales to customers. Goods Deductible in the year paid. If you make
that have been sold, but not yet paid for, and Loans to clients and suppliers. If you loan a payment on a loan you guaranteed, you can
services that have been performed, but not yet money to a client, supplier, employee, or distrib- deduct it in the year paid, unless you have
paid for, are recorded in your books as either utor for a business reason and you’re unable to rights against the borrower.
accounts receivable or notes receivable. After a collect the loan after attempting to do so, you
reasonable period of time, if you have tried to have a business bad debt. Rights against a borrower. When you
collect the amount due, but are unable to do so, make payment on a loan you guaranteed, you
the uncollectible part of the receivables be- Debts owed by political parties. If a political may have the right to take the place of the
comes a business bad debt. party (or other organization that accepts contri- lender. The debt is then owed to you. If you
Accounts or notes receivable valued at fair butions or spends money to influence elections) have this right, or some other right to demand
market value (FMV) when received are deducti- owes you money and the debt becomes worth- payment from the borrower, you can’t claim a
ble only at that value, even though the FMV less, you can claim a bad debt deduction only if bad debt deduction until these rights become
may be less than the face value. If you pur- all of the following requirements are met. partly or totally worthless.
chased an account receivable for less than its 1. You use an accrual method of accounting.
face value, and the receivable subsequently be- Joint debtor. If two or more debtors jointly
comes worthless, the most you’re allowed to 2. The debt arose from the sale of goods or owe you money, your inability to collect from
deduct is the amount you paid to acquire it. services in the ordinary course of your one doesn’t enable you to deduct a proportion-
trade or business.
You can claim a business bad debt de- ate amount as a bad debt.
! duction only if the amount owed to you 3. More than 30% of your receivables ac- Sale of mortgaged property. If mortgaged or
crued in the year of the sale were from
CAUTION was previously included in gross in- pledged property is sold for less than the debt,
come. This applies to amounts owed to you sales to political parties. the unpaid, uncollectible balance of the debt is
from all sources of taxable income, including 4. You made substantial and continuing ef- a bad debt.
sales, services, rents, and interest. forts to collect on the debt.
Accrual method. If you use an accrual Loan or capital contribution. You cannot When a Debt Becomes
method of accounting, you generally report in- claim a bad debt deduction for a loan you made
come as you earn it. You can only claim a bad to a corporation if, based on the facts and cir- Worthless
debt deduction for an uncollectible receivable if cumstances, the loan is actually a contribution
you have previously included the uncollectible to capital. A debt becomes worthless when there is no
amount in income. longer any chance the amount owed will be
If you qualify, you can use the nonac- Debts of an insolvent partner. If your busi- paid. This may occur on the date the debt is
crual-experience method of accounting, dis- ness partnership breaks up and one of your for- due or prior to that date.
cussed later. Under this method, you don’t have mer partners becomes insolvent, you may have
to accrue income that, based on your experi- to pay more than your pro rata share of the part- To demonstrate worthlessness, you must
ence, you don’t expect to collect. nership's debts. If you pay any part of the insol- only show that you have taken reasonable
vent partner's share of the debts, you can claim steps to collect the debt but were unable to do
Cash method. If you use the cash method a bad debt deduction for the amount you paid so. It isn’t necessary to go to court if you can
of accounting, you generally report income that is attributable to the insolvent partner's show that a judgment from the court would be
when you receive payment. You can’t claim a share. uncollectible. Bankruptcy of your debtor is gen-
bad debt deduction for amounts owed to you erally good evidence of the worthlessness of at
because you never included those amounts in Business loan guarantee. If you guarantee a least a part of an unsecured and unpreferred
income. For example, a cash basis architect debt that subsequently becomes worthless, the debt.
can’t claim a bad debt deduction if a client fails
to pay the bill because the architect's fee was
never included in income.
Page 42 Chapter 10 Business Bad Debts