Section 166 Review: How to Deduct Bad Debts

Internal Revenue Code Section 166 provides a mechanism for taxpayers to deduct debts that have become uncollectible. This provision allows both individuals and businesses to adjust their taxable income to reflect the economic loss from such bad debts. The purpose of this rule is to align a taxpayer’s reported income with their actual financial position. By permitting a deduction, the tax code ensures that income which was anticipated but never received does not result in an unfair tax burden.

This framework is built upon specific requirements that must be met before a deduction can be claimed. Taxpayers must navigate definitions, classifications, and documentation standards to substantiate their claim. Understanding these rules is fundamental for accurately calculating tax liability and managing the financial consequences of uncollected obligations.

Defining a Bona Fide Debt

Before any consideration of a deduction, a taxpayer must first establish the existence of a “bona fide debt.” This means the debt must originate from a legitimate debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed sum of money. Without this, what might appear as a loan could be reclassified by the IRS as a gift or a capital contribution, neither of which is deductible as a bad debt.

To determine if a bona fide debt exists, several indicators are examined. The presence of a formal written instrument, such as a promissory note, is strong evidence. Other factors include a specified interest rate, a clear repayment schedule, and any collateral provided to secure the loan. These elements demonstrate a mutual understanding and intent for the funds to be repaid.

The substance of the transaction, not just its form, is what ultimately matters. For instance, a documented loan to a supplier that becomes uncollectible would likely qualify. In contrast, a casual advance to a family member with no written terms or expectation of repayment would probably be viewed as a gift. The taxpayer must be able to prove that at the time the funds were advanced, there was a genuine intention to create a debt.

Classifying the Type of Bad Debt

Once a bona fide debt is established, it must be classified as either a business or nonbusiness bad debt, a distinction with significant tax implications. A business bad debt is one that is created or acquired in connection with the taxpayer’s trade or business. This includes debts from credit sales to customers or loans to suppliers, where the primary motive for the debt is business-related.

The tax treatment for business bad debts is more favorable. They are deductible as ordinary losses, which means they can be used to offset a wide range of income, including salaries, profits, and interest. If the bad debt deduction creates or increases a net operating loss for the year, that loss can be carried to other years to reduce taxes.

On the other hand, a nonbusiness bad debt is any debt that does not meet the criteria for a business debt. Common examples include personal loans to friends or family, or investment-related loans not part of the taxpayer’s primary business. A nonbusiness bad debt is always treated as a short-term capital loss, regardless of how long the debt was held.

This classification impacts the value of the deduction. Short-term capital losses must first be used to offset capital gains. If a taxpayer has no capital gains, the deduction against other types of income is limited to $3,000 per year for individuals. Any remaining loss must be carried forward to future years.

Establishing Debt Worthlessness

A deduction is only permitted in the year a debt becomes worthless. This requires the taxpayer to demonstrate with objective evidence that there is no longer any reasonable prospect of being repaid. The taxpayer must show they have taken reasonable steps to collect the debt, although they are not required to pursue legal action if it is clear a court judgment would be uncollectible.

For both business and nonbusiness debts, a deduction can be taken when the debt is determined to be wholly worthless. Events that can serve as proof of total worthlessness include the debtor’s bankruptcy, insolvency, disappearance, or death. Another indicator is a legal judgment that cannot be satisfied because the debtor has no assets. A voluntary cancellation of the debt by the creditor does not, by itself, prove worthlessness.

A unique rule applies exclusively to business bad debts, allowing for a deduction when a debt becomes partially worthless. This means a business can deduct the specific portion of a debt identified as uncollectible within a given tax year, even if there is a chance of recovering the remainder. For example, if a company in bankruptcy announces that creditors will receive only 20 cents on the dollar, a business creditor could claim a deduction for the 80% of the debt considered worthless. This option is not available for nonbusiness bad debts.

Claiming the Bad Debt Deduction

To claim a deduction for a bad debt, taxpayers must use the specific charge-off method, as it is the only method allowed by the IRS. For tax purposes, charging off a debt signifies the taxpayer’s formal recognition that a specific amount is uncollectible. This charge-off must occur during the taxable year for which the deduction is claimed.

The process for reporting the deduction differs based on the debt’s classification. Business bad debts are deducted on the tax form associated with the specific business. For a sole proprietor, this would be on Schedule C (Form 1040), for corporations on Form 1120, and for farmers on Schedule F (Form 1040).

Nonbusiness bad debts follow a different reporting path as short-term capital losses. The taxpayer must first report the worthless debt on Form 8949, Sales and Other Dispositions of Capital Assets. On this form, the taxpayer enters the debtor’s name, the amount of the debt as the cost basis, and zero as the sales price. The resulting loss from Form 8949 is then carried over to Schedule D (Form 1040), and a statement must be attached to the return detailing the debt, collection efforts, and the reason for determining it is worthless.