What Can You Write Off in Bankruptcies for Business Losses?

Filing for bankruptcy due to business losses can be a difficult decision, but it may provide relief by eliminating or restructuring certain debts. Understanding what financial obligations can be written off is essential for making informed choices and planning for the future.

Certain debts qualify for discharge, and businesses may also be eligible for tax deductions on uncollected revenue. Properly handling secured claims and maintaining accurate financial records are key to managing the process effectively.

Dischargeable Debt Categories

When a business files for bankruptcy, some financial obligations can be eliminated. Unsecured debts, which are not backed by collateral, are among the most commonly discharged. These include credit card balances, medical bills related to business operations, and personal loans taken out to cover company expenses. Since these debts lack collateral, creditors cannot recover funds once they are discharged.

Business-related lease obligations can also be eliminated. If a company signed a long-term lease for office space or equipment but can no longer afford the payments, bankruptcy may allow for termination without future penalties. This is especially relevant in Chapter 7 cases, where the business shuts down entirely, but it can also apply in Chapter 11 restructurings if the lease is deemed financially burdensome.

Legal judgments and lawsuit-related debts may also be discharged, depending on the nature of the claim. If a business was sued for breach of contract or unpaid invoices, those liabilities can often be eliminated. However, debts resulting from fraud, willful misconduct, or regulatory fines typically remain enforceable. Courts closely examine these cases, and creditors may challenge the discharge if they believe the debt arose from dishonest business practices.

Tax Deductions for Bad Debts

Businesses that extend credit to customers or suppliers may face situations where payments are never received. When these unpaid amounts become uncollectible, they can often be written off as bad debt expenses on tax returns, reducing taxable income. The IRS allows businesses to claim deductions for bad debts under Section 166 of the Internal Revenue Code, but specific requirements must be met.

To deduct a bad debt, the business must show that the amount was previously included in taxable income and that there is no reasonable expectation of recovery. For businesses using the accrual accounting method, this typically applies to sales made on credit where revenue was recognized but never collected. Cash-basis taxpayers generally cannot claim bad debt deductions since income is only recorded when received.

Bad debts qualifying for deductions fall into two categories: business bad debts and nonbusiness bad debts. Business bad debts arise from credit sales, loans to clients or suppliers, or unpaid fees for services rendered. These are considered ordinary losses and can be fully deducted against business income. Nonbusiness bad debts, which stem from personal loans unrelated to business operations, are treated as short-term capital losses and subject to capital loss limitations.

Proper documentation is essential when claiming a bad debt deduction. Businesses must provide evidence of collection efforts, such as invoices, correspondence with debtors, and records of attempted payments. Writing off a debt without sufficient proof can lead to IRS scrutiny, potentially resulting in disallowed deductions and penalties. If a debt is partially recovered in a later tax year, the recovered amount must be reported as income in the year it is received.

Handling Partially Secured Claims

When a business owes a debt that is partially secured, the creditor holds a claim backed by collateral, but the debt exceeds the asset’s value. This means part of the debt is secured while the remaining portion is unsecured. The treatment of these claims in bankruptcy depends on the type of filing and the valuation of the collateral.

In Chapter 11 reorganizations, businesses may attempt to restructure partially secured claims through a process known as “cramdown,” where the court modifies loan terms based on the collateral’s fair market value. For example, if a business owes $200,000 on equipment valued at $120,000, the secured portion of the debt is limited to $120,000, while the remaining $80,000 is reclassified as unsecured. The secured portion may be repaid under renegotiated terms, often with a reduced interest rate or extended maturity. The unsecured portion, like other general unsecured debts, may be discharged or repaid at a reduced amount under the reorganization plan.

Collateral valuation plays a significant role in determining how much of a claim remains secured. Courts may rely on appraisals, market comparisons, or liquidation value assessments to establish a fair estimate. Creditors often challenge these valuations, as a lower figure shifts more of the claim into unsecured status, reducing their recovery. Debtors must provide strong supporting evidence, such as professional appraisals or recent sales of comparable assets, to justify their proposed valuation.

In Chapter 7 liquidations, partially secured claims are handled differently, as assets are sold off to repay creditors. If the collateral is auctioned for less than the outstanding balance, the secured creditor receives the proceeds, while the remaining shortfall is treated as an unsecured claim. Since unsecured creditors typically receive little to no repayment in liquidation cases, partially secured lenders often face significant losses. Some may negotiate with the bankruptcy trustee to recover additional funds if they believe the asset was undervalued or improperly sold.

Documenting Write-Offs for Financial Records

Accurate documentation of financial write-offs is necessary for compliance with Generally Accepted Accounting Principles (GAAP) and IRS regulations. When recording a business loss in bankruptcy, companies must ensure that financial statements reflect the impact correctly. Write-offs should be categorized appropriately within the general ledger to distinguish between operating losses, asset impairments, and uncollectible receivables. Misclassification can lead to misstated financial reports, which may trigger regulatory scrutiny or audit risks.

Businesses undergoing bankruptcy must also adjust their balance sheets to reflect discharged liabilities. Under GAAP, liabilities that are legally forgiven should be removed from the books through a reduction in the corresponding debt account, with an offsetting gain recorded under “Other Income” unless specific exceptions apply. However, under IRS rules, cancellation of debt income (CODI) may be excluded from taxable income in bankruptcy cases, provided the taxpayer meets eligibility requirements under Section 108 of the Internal Revenue Code. Proper reconciliation between tax filings and financial statements ensures that discrepancies do not arise during audits.