Lending money is a part of life and is also a normal practice for many types of businesses. But with lending money comes the real risk that it will never be repaid. The IRS allows for certain types of debt to be written off, classified as “bad debt.” However, the IRS also closely scrutinizes bad debt and it is not uncommon for taxpayers to see their tax returns audited or adjusted. If this happens to you, you have the right to appeal and knowing the following information will help your odds of success on appeal.
What is Bad Debt?
Bad debt is money that you have personally, or that your business has loaned out but was not repaid and is now worthless. Bad debts are classified by the IRS as either “business” bad debts or “nonbusiness” bad debts.
Business bad debts are debts “created or acquired in connection with a trade or business of the taxpayer” or “the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.” Common examples of this include: (1) loans to made in the course of business; (2) customer financing offers; and (3) credit guarantees. Business bad debts may be deducted from the taxpayer’s income. In contrast, all other bad debts are classified as nonbusiness bad debts and can only be reported as a short-term capital loss.
If you believe that your debt is a business debt, it is in your interest to obtain or maintain documentation to demonstrate the proximity of the bad debt to your business. These records will be invaluable for tax appeal purposes if your return is audited or adjusted.
Is the Debt Worthless?
A taxpayer can only report a bad debt loss in the year that the debt became worthless. Worthlessness is a key element to properly reporting bad debt, and something that the IRS hones in on when examining a bad debt claim. To demonstrate worthlessness, a taxpayer has to exhaust all reasonable means of collecting the debt. In other words, given the circumstances of the debt, the debt is in all probability uncollectable. Further, if there is any security on the debt, that security must be worthless. The security may not even hold future value.
Consider a Tax Appeal
The IRS looks hard at tax returns that report bad debt, often resulting in rejecting the taxpayers claim of bad debt. If you have taken all reasonable steps to collect on bad debt, but IRS has denied your bad debt deduction, contact the Law Office of Robert S. Thomas. While the IRS looks harshly at certain deductions, they are not infallible. If you call us for a consultation, we can help you determine whether a tax appeal would be worth your while. I have more than twenty years of legal experience in IRS taxation and am licensed to practice in Federal Tax Court. Contact my office today at 847-392-5893 to schedule an appointment or visit our website today.