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.

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Photo of Thomas Gray Thomas Gray

As both an accountant and an attorney, Tom understands tax issues from every perspective. When clients undertake transactions or investments, he seamlessly navigates complex tax laws and considerations at stake, allowing clients to focus solely on their business goals.

Photo of Thomas Phelan Thomas Phelan

Tom focuses his practice on federal and international income tax, including providing advice to clients on mergers and acquisitions, reorganizations, and cross-border restructurings. He has experience with tax issues related to corporate finance transactions and the taxation of financial instruments.

Photo of David Fournier David Fournier

David represents various interests in complex bankruptcy proceedings in the District of Delaware and other jurisdictions. His clients include corporate debtors, secured and unsecured creditors, official creditors’ committees, foreign representatives, and others. David also has extensive experience as a mediator in bankruptcy litigation.

Photo of Evelyn Meltzer Evelyn Meltzer

Evelyn focuses her practice on corporate bankruptcy, insolvency, distressed M&A, and creditors’ rights. With more than 20 years of experience, Evelyn understands all facets of a problem or opportunity, strategically devising insightful, innovative, and practical solutions that protect and advance her clients’ interests.

Photo of Kenneth Listwak Kenneth Listwak

Ken has broad experience in bankruptcy and reorganization matters, including adversary proceedings and contested matters in complex bankruptcy cases, and advising and guiding clients through complex issues involving bankruptcy law and Delaware legal practice.

Photo of Tori Lynn Remington Tori Lynn Remington

Tori is an associate in the firm’s Finance and Financial Restructuring + Insolvency practice groups. She has been involved in complex chapter 11 proceedings and litigation matters, representing various parties in interest, including debtors-in-possession, DIP lenders, stalking horse purchasers, and creditors. Tori also…

Tori is an associate in the firm’s Finance and Financial Restructuring + Insolvency practice groups. She has been involved in complex chapter 11 proceedings and litigation matters, representing various parties in interest, including debtors-in-possession, DIP lenders, stalking horse purchasers, and creditors. Tori also has experience in the Court of Chancery representing assignees in Delaware ABCs.

Heather Smillie

Heather is an associate in the firm’s Financial Restructuring + Insolvency Practice Group. She has represented corporate debtors, creditors, and lenders in complex chapter 11 cases, out-of-court restructurings, dissolutions, and wind-downs. Heather is experienced in guiding clients through the chapter 11 process and…

Heather is an associate in the firm’s Financial Restructuring + Insolvency Practice Group. She has represented corporate debtors, creditors, and lenders in complex chapter 11 cases, out-of-court restructurings, dissolutions, and wind-downs. Heather is experienced in guiding clients through the chapter 11 process and has regularly appeared and represented clients in the U.S. Bankruptcy Court for the District of Delaware.