Business Vs. Non-Business Bad Debt Write Offs

A bad debt occurs when you are owed money and are unable to collect from the borrower. The tax treatment of this kind of loss varies quite dramatically depending upon whether the loss is attributable to a business purpose. A legitimate business bad debt may be deducted in full or part on the business tax return. A non-business bad debt is reported as a short-term capital loss and as a result is subject to capital loss limitations. Because capital losses are limited to $3,000 per year (the balance of losses can be carried forward) an individual suffering a large non-business bad debt may never be able to effectively write the loss off over their lifetime.

The IRS defines a business bad debt as a loss arising from the worthlessness of debt that was either created or acquired in your trade or business or closely related to your trade or business when it became worthless. The primary motive for creating the debt in the first place must be business related.

A loan to a relative or friend may be considered a gift if there is an understanding that it may not be repaid. Gifts to friends and relatives are not deductible. If it is considered a loan (it should be well documented) it will be considered a non-business bad debt.

Cash basis taxpayers may not take a bad debt deduction for money that was expected to be received for the sale of a good or service but never collected. For example, an architect that spends hours drawing up plans for an apartment building for a contractor doesn't get paid. The architect cannot deduct the loss of expected revenue as a bad debt. On the other hand, if the architect loaned money to the contractor for legal fees relating to a proposed zoning change and didn't get paid back has experienced the annoyance of incurring a legitimate business bad debt. The IRS considers the money loaned as being previously included in income and appropriately taxed so if this money is subsequently lost it is proper accounting to recognize the loss as a business bad debt for tax reporting purposes.

A business bad debt can come about from a wide variety of situations. If money is loaned to a client, supplier, employee or distributor for business purposes and later becomes uncollectable a business bad debt is created. The IRS, based on the facts and circumstances, may consider a loan to a corporation to be a contribution to capital and the loss will be a considered a capital loss.

An investor that loaned money to Enron via a purchase of bonds in their brokerage account suffered a non-business capital loss when Enron was unable to repay the loan. A supplier that advanced Enron money via a short term loan will have grieved over their business related bad debt. In both cases a bad debt was suffered but the tax treatment is different because of the circumstances.