Why Revenue Procedure 85-19 Is Obsolete
Learn how tax law reform made a once-common bad debt accounting method obsolete and established the current requirements for claiming this type of deduction.
Revenue Procedure 85-19 was administrative guidance from the Internal Revenue Service (IRS) that provided a streamlined process for changing an accounting method for bad debts. It allowed businesses to switch to the reserve method, which was based on estimating future uncollectible accounts, without requesting special permission from the IRS. This procedure eliminated procedural hurdles for what was then a common accounting practice.
The Obsolescence of the Reserve Method
The relevance of Revenue Procedure 85-19 ended when the underlying law changed. This occurred with the passage of the Tax Reform Act of 1986, which repealed the reserve method for deducting bad debts for the vast majority of businesses.
Instead of deducting an estimated amount for future losses, the law now required most taxpayers to use the specific charge-off method. This means a deduction can only be claimed when a specific debt is proven to be uncollectible. A procedure granting automatic consent to switch to the reserve method no longer had a purpose, as the method itself was no longer an option for most entities.
The Tax Reform Act of 1986 included narrow exceptions. The reserve method remains permissible for certain financial institutions, such as small banks and thrift institutions with assets below a specified threshold. For all other businesses, the repeal was absolute, making the specific charge-off method the only available option.
Because the reserve method was removed from the tax code for most taxpayers, the instructions in Revenue Procedure 85-19 became irrelevant. The procedure is now a historical footnote, showing how IRS guidance can be invalidated by changes in tax law.
The Specific Charge-Off Method Explained
With the reserve method no longer available to most businesses, the specific charge-off method is the mandatory approach for deducting bad debts. This method allows a deduction only in the tax year that a debt becomes worthless. The loss is recognized when it is actually sustained, linking the deduction directly to an identifiable event without any estimation.
To claim a deduction, a taxpayer must demonstrate that the debt is uncollectible by showing that reasonable steps were taken to collect the amount owed. Evidence can include letters to the debtor, records of phone calls, or documentation of legal action. The standard is based on whether facts and circumstances indicate there is no longer a reasonable expectation of recovery.
Under the specific charge-off method, there is a distinction between business and nonbusiness bad debts, which receive different tax treatment. A business bad debt originates from the operation of the taxpayer’s trade or business. These are deductible as ordinary losses against business income and can offset other income without the limitations applied to capital losses.
Nonbusiness bad debts were not acquired or created in connection with the taxpayer’s trade or business, such as a personal loan to a friend. For a nonbusiness bad debt to be deductible, it must be wholly worthless, as no deduction is allowed for a partially worthless nonbusiness debt. These losses are treated as short-term capital losses and are subject to limitations on how much can be deducted against ordinary income in a given year.
How to Claim a Bad Debt Deduction
After determining a specific debt is worthless, a taxpayer must claim the deduction on their tax return. The burden of proof rests with the taxpayer, so documentation is a requirement. Records should substantiate the debt, the basis in the debt, and the fact that it has become worthless.
Documents should include the original loan agreement, promissory note, or other evidence of the debt. Taxpayers must also keep records of their collection efforts, such as copies of correspondence with the debtor, emails, registered mail receipts, and any legal filings or judgments obtained. These records are necessary to defend the deduction if the IRS examines the return.
The process for claiming the deduction depends on the nature of the debt. For a sole proprietor reporting a business bad debt, the loss is reported as an expense on Form 1040, Schedule C, “Profit or Loss from Business.” This directly reduces the net profit or increases the net loss from the business.
For a nonbusiness bad debt, the worthless debt is reported on Form 8949, “Sales and Other Dispositions of Capital Assets.” The taxpayer provides details of the debt, showing the proceeds as zero and the date it became worthless. The loss from Form 8949 is then carried to Schedule D, “Capital Gains and Losses,” where it is treated as a short-term capital loss.