Can You Write Off a Bad Debt?
Most small businesses have receivables that cannot be collected. These receivables can be from the sale of products, providing services to customers, or a combination of the two.
Whether or not a bad debt deduction will apply generally depends upon which accounting method is used (either the cash or accrual method). Why does this make a difference? Let’s look at what happens under both methods of accounting.
A taxpayer's loan to a customer or supplier may be a business debt if there is some element of necessity for the loan, which is proximately related to the taxpayer's business. An example is a builder who makes advances to a building material supplier and never receives the supplies. In such cases, assuming the taxpayer can prove the debt is worthless, the loan will result in a bad debt for either an accrual or cash basis taxpayer.
Proof of Worthlessness – Proving a debt (or receivable) is worthless requires the taxpayer or business to show that the debt has become worthless and that reasonable steps were taken to collect the debt.
Non-Business Bad Debts – Some bad debts may actually be personal debts, such as personal loans to individuals. In those cases, the bad debt is not deducted as a business expense but is treated as a short-term capital loss on Schedule D instead. The bottom loss for any year on Schedule D is limited to $3,000 ($1,500 for married filing separate taxpayers). Unless the Schedule D contains gains to offset additional losses, a non-business bad debt could be limited to $3,000 per year. The good news is that any amount not deductible in a particular year carries over to the next subsequent year.
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