Bad Debts - Nonbusiness Introduction

Introduction:

If someone owes you money that you cannot collect, you have a bad debt. There are two kinds of bad debts - business and nonbusiness.

Bad debts are deductible only if the amount owed has been lent or previously included in your income. If you are a cash basis taxpayer, as most individuals are, you may not take a bad debt deduction for expected income you have not received, since it was never included in your income. A business bad debt, generally, is one that comes from operating your trade or business. A business deducts its bad debts from gross income when figuring its taxable income. Business bad debts may be deducted in part or in full.

All other bad debts are nonbusiness. Nonbusiness bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless nonbusiness bad debt. You must establish that you have taken reasonable steps to collect the debt and that the debt is worthless. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You may take the deduction only in the year the debt becomes worthless. A debt becomes worthless when there is no longer any chance the amount owed will be paid. You do not have to wait until the debt comes due.

A nonbusiness bad debt is reported on Schedule D (of Form 1040) Part 1 as a short-term capital loss. It is subject to the capital loss limit of $3,000 per year. This limit is $1,500 if you are married filing a separate return. A non-business bad debt requires a separate detailed statement attached to the schedule D.

Nonbusiness Debts

A nonbusiness bad debt is deductible for the year it becomes wholly worthless, and is treated as a short-term capital loss (special limitations apply).

Individuals: the deduction is claimed as a short-term capital loss on Schedule D.

Partnerships: the deduction is claimed on Schedule D.

A statement must accompany the return.

Sample Statement:

Taxpayer Name(s):___________________________________

Tax Form:___________________

Tax Schedule:________________

Taxpayer identification number: _________________________

(1) Description of the debt: ____________________________
__________________________________________________
__________________________________________________
__________________________________________________

Amount: ____________

Interest Rate: ________

Maturity:

Original date: ________

Maturity Date: ________

Collateral: ________________________________________
________________________________________________
________________________________________________

Payment amount: ___________________________________

Payment Frequency: _________________________________

(2) Name of the debtor: _______________________________
_________________________________________________

Business or family relationship of the debtor to the taxpayer:
_________________________________________________
_________________________________________________

(3) The efforts made to collect the debt: ___________________
_________________________________________________
_________________________________________________
_________________________________________________

(4) the reasons for determining that the debt became worthless:
________________________________________________
________________________________________________
________________________________________________
________________________________________________

All debts owed to corporations are treated as business debts.

Business Debts

Business debts may be deducted when either wholly or partially worthless. In no case may a deduction be claimed in a year subsequent to that in which the debt becomes wholly worthless. The deduction for partially worthless debts is limited to the amount which is charged off by the taxpayer in the current year.

Individuals should claim the deduction on Schedule C (Form 1040).

Corporations should claim the deduction on Form 1120, 1120A, or 1120S.

Partnerships should claim the deduction on Form 1065. A statement of the type described above, with respect to nonbusiness debts, must be attached to the return.

Proof of Loss

You must be able to locate and present to the Revenue Agent evidence about the bad debt.

Proof the debt existed - promissory notes

Proof there was a valid debt - security interest filings, UCC forms filed

Proof you loaned the money - canceled checks proving the money was loaned, how much, when and the fact that YOU are the one who loaned the money

Proof you made attempts to collect the money - records of written demands, telephone records, legal services, proof of service, petitions filed, etc.

Proof the debtor could not or would not pay - bankruptcy filings, responses from debtor's legal counsel, etc.