IRS Publication 954: Deducting Bad Debts & Losses

IRS Publication 954, “Tax Guide to Bad Debts,” provides the framework for understanding and properly reporting losses from uncollectible debts and devalued investments. The publication addresses three distinct categories of financial loss: bad debts, which can be either business or nonbusiness related; worthless securities such as stocks and bonds; and losses on deposits in insolvent financial institutions. Each category has its own set of criteria for determining when a loss can be claimed and how it must be reported on a tax return.

Deducting Nonbusiness Bad Debts

A nonbusiness bad debt must originate from a “bona fide debt” to be deductible. This requires a true debtor-creditor relationship where both parties intended for the money to be a loan, not a gift, with a legitimate expectation of repayment. Loans to relatives or friends are often scrutinized and may be considered gifts if there was no clear intention of repayment.

For the debt to be deductible, it must be entirely worthless. A debt becomes worthless in the year that facts indicate there is no longer any reasonable expectation of being paid. Taxpayers must demonstrate they have taken reasonable steps to collect the money owed, which may not require legal action if a judgment would be uncollectible. You can only claim the deduction in the year the debt becomes worthless, and no deduction is allowed for a partially worthless nonbusiness debt.

A nonbusiness bad debt is treated as a short-term capital loss. This loss is reported on Form 8949, “Sales and Other Dispositions of Capital Assets,” and then carried to Schedule D, “Capital Gains and Losses,” where it can offset capital gains.

Deducting Business Bad Debts

A business bad debt is a loss from a debt created or acquired within your trade or business, such as unpaid credit sales or loans to clients for a business purpose. If your primary motive for the debt is business-related, it qualifies. Loans made by a corporation are always considered business debts.

Business bad debts are deducted as ordinary losses, which directly reduces gross income. Businesses use the “specific charge-off method,” allowing a deduction in the tax year a debt becomes partially or wholly worthless. Accrual-method taxpayers have specific procedures for writing off uncollectible accounts receivable.

The deduction is claimed on the appropriate business tax form. Sole proprietors and single-member LLCs report this on Schedule C (Form 1040), partnerships on Form 1065, S corporations on Form 1120-S, and C corporations on Form 1120.

Claiming Losses on Worthless Securities

To claim a loss on a worthless security, you must understand what the IRS defines as a “security,” which includes investments like stocks, stock rights, and bonds. The deduction is only available when the security becomes completely worthless, meaning it has no remaining value and no potential to regain value. Partial worthlessness of a security is not deductible.

A security is considered completely worthless upon an “identifiable event.” This event serves as definitive proof that the investment is lost, such as a company’s bankruptcy, its liquidation, or the formal termination of its business operations. The mere decline in a stock’s price is not sufficient; the security must be entirely without value.

The loss is treated as if it resulted from a sale that took place on the last day of the tax year in which the security became worthless. This rule determines whether the loss is classified as short-term or long-term, based on how long you held the security. These losses are reported on Form 8949 and then carried to Schedule D.

Handling Losses on Deposits in Insolvent Financial Institutions

When a bank, credit union, or other financial institution becomes insolvent, depositors may suffer a loss on their accounts. IRS Publication 954 provides guidance on how to handle these situations, offering taxpayers a choice in how they treat the loss.

One option is to treat the loss as a nonbusiness bad debt. This is deductible as a short-term capital loss in the year the amount of the loss can be reasonably estimated and is reported on Form 8949 and Schedule D.

A second choice is to treat the loss as a casualty loss, which allows for an itemized deduction on Schedule A (Form 1040) via Form 4684. A third option allows the loss to be treated as an ordinary loss, which can also be deducted as an itemized deduction on Schedule A.

Documentation Needed to Support Your Deduction

To claim a deduction for a bad debt or worthless security, you must maintain thorough documentation to substantiate your claim. For bad debts, this evidence should include the original loan agreement or promissory note that established the debt. You should also keep records of any payments received and proof of your efforts to collect the debt, such as copies of letters or emails demanding repayment.

For losses on worthless securities, your documentation must establish both your ownership and the complete loss of value. Keep brokerage statements that show the purchase of the security and your cost basis. You will also need definitive proof of the event that rendered the security worthless, such as a notice from a bankruptcy court or a public announcement confirming the company’s liquidation.

If you are claiming a loss on deposits in an insolvent financial institution, the required documentation will come from the institution or its receiver. You should retain any official statements or notices that confirm the closure of the institution and the amount of your uninsured loss. These documents serve as the primary evidence for your deduction.