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Claiming business bad debt deductions.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Individuals," 2d edition, by Elizabeth DiTommaso, Helen Gardner and Terry W. Lovelace, published by Practitioners Publishing Company, Fort Worth, Tex., 1993.

Facts: Jack Greenthum owns and operates Bloomin Deals, a wholesale nursery business. The business is a sole proprietroship and uses the accrual method of accounting. * Jack sells on credit to a select few longtime customers; otherwise, sales are for cash only. At the end of the year, Bloomin Deals' accounts receivable reflect a balance of $48,000. * Jack approached his tax adviser in December with the information for year-end tax planning, including Schedule C data from the nursery business. He relates the following information about the business: (1) He is experiencing problems in collecting $12,000 in accounts receivable from one of his longtime customers, Jerry Jasmine, owner of Jasmine's Ground Covers. (2) In February 1995, Larry Ligustrum, the owner of Ligustrum's Plants, Jack's largest customer and a very good friend, intimated that he was in need of financial help. Larry needed an additional $20,000 line of credit from the bank for use in his business; however, the bank wanted collateral or a substantial guarantor before granting the loan. Larry did not have sufficient security, so Jack agreed to guarantee the line of credit as a favor to his friend. In return, Larry promised to buy exclusively from Jack in the future. Larry defaulted on the first note payment on Oct. 1, 1995; Jack made the required $10,000 payment as the guarantor. (3) Larry Ligustrum tells Jack he may file for bankruptcy in 1996. At the end of 1995, Ligustrum's Plants owed Bloomin Deals $4,000 plus the $10,000 loan payment. Issues: Does Jack have a bad debt deduction for 1995? * What must be done to substantiate a bad debt deduction?

Analysis

A business bad debt is a loss from a debt created or acquired in connection with a taxpayer's trade or business. A business bad debt also includes any other worthless debt if there is a very close relationship between the debt and the taxpayer's trade or business. The debt must be closely related to the activity of a taxpayer's business or the taxpayer must have a predominant business reason for entering into the transaction as a creditor. Most accrual-basis taxpayers must use the specific charge-off method of computing the bad debt deduction, which allows the taxpayer to deduct business debts at the point at which the debt becomes wholly or partially worthless (as long as the income that created the debt was previously included in income). A cash-basis taxpayer can deduct a bad debt only if an actual cash loss has been sustained or if the amount deducted was previously included in income.

A business bad debt generally originates as a result of credit sales to customers representing goods sold or services provided. If a taxpayer sells goods or provides services on credit and the account receivable subsequently becomes worthless, a business bad debt deduction is permitted only if income arising from the creation of the account receivable was previously included in income. Business bad debts can also take the form of loans to suppliers, clients, employees and distributors. Additionally, a guarantor is allowed a business bad debt deduction for any payment made in the capacity as guarantor, as long as the reason for guaranteeing the debt was closely related to the trade or business. In this situation, the guarantor's payment results in a loan to the debtor and the taxpayer is allowed a bad debt deduction once the loan becomes worthless.

Partial worthlessness is determined at the close of the deduction year and not by subsequent events. The bad debt deduction for a partially worthless debt is limited to the amount charged off on a taxpayer's books during the year. However, a taxpayer is not required to annually charge off and deduct partially worthless debts. The taxpayer may wait until more of the debt is collected or has become totally worthless; however, in no event can a taxpayer deduct any part of the bad debt in a year after the debt has become totally worthless.

A totally worthless debt is deductible only in the year it becomes totally worthless. The deduction cannot include amounts previously deducted when the debt was determined to be only partially worthless. In contrast to partially worthless debts, a charge-off on the taxpayer's books is not required; however, if the IRS later rules that the debt is only partially worthless, the bad debt deduction is only allowed to the extent of the amount actually charged off on the taxpayer's books. Accordingly, tax advisers should be certain to charge off an amount on the taxpayer's books if partial worthlessness is suspected--even if a tax deduction is not claimed--in order to preserve the deduction if later disputes arise as to total worthlessness.

If a previously deducted business bad debt is fully or partially collected in a later year, the portion recovered must be included in gross income of the taxpayer's business in the year recovered. However, under a tax benefit rule, taxpayers can exclude from income the amount of the bad debt deduction that did not reduce their tax in the year it was deducted.

There are no definitive guidelines for determining if and when a debt becomes worthless. Worthlessness is evidenced by the fact that legal action to enforce payment would result in an uncollectible judgment or by a settlement in bankruptcy. The act of bankruptcy itself generally is an indication of at least partial worthlessness, and many times will establish worthlessness if it is obvious before the settlement date that there are no assets to be distributed to the creditor. However, the mere fact that bankruptcy proceedings instituted against the debtor are terminated (settled) in a later year does not entitle the taxpayer to a bad debt deduction in the settlement year if the debt actually became worthless in an earlier year.

Jack Greenthum's account receivable of $12,000 from Jasmine's Ground Covers qualifies as a business debt because:

1. The debt is closely related to the activity of Jack's nursery business, and

2. A dominant business reason existed for Bloomin Deals to enter into the business transaction with Jasmine's as the creditor.

Jack must be able to prove that the receivable of $12,000 due from Jasmine's is partially or wholly worthless. Jasmine's Ground Covers has not filed for bankruptcy nor has a judgment been entered against the company. However, Jack may be able to establish uncollectibility through reliance on other facts. If he can establish that the debtor has no assets or only nominal assets and has little prospect of continuing in business, a deduction may be allowed. However, insolvency alone, particularly when a debtor continues to operate a business, is not indicative of a debt's worthlessness. Jack also needs to document any collection efforts made either by him or his employees (such as letters or phone calls) or through an agent (such as an attorney or collection agency).

However, if Jack did not begin these usual means of collection or determine whether or not Jasmine's had the ability to pay during 1995, it is unlikely that he can sustain a business bad debt deduction in that year. In this case, his tax adviser should advise him to initiate these efforts during the 1996 tax year for this debt and any other account receivable that Jack feels may be uncollectible. His adviser should also advise him of the importance of actually making a book entry recognizing a specific bad debt write-off. If a debt claimed to be totally worthless is not charged off on Jack's books and the IRS later rules that the debt is only partially worthless, Jack will not be allowed any deduction because a deduction for a partially worthless bad debt is limited to the amount actually charged off.

Jack's personal guarantee and payment related to Larry Ligustrum's credit line also appears business-related, since his dominant motive for guaranteeing the debt was proximately related to Bloomin Deals. Ligustrum's Plants is Bloomin Deals' largest customer. Additionally, Jack received a promise from Larry that Ligustrum's Plants would buy exclusively from Jack. These facts should establish a sufficient business motivation. Although Ligustrum's Plants may not file for bankruptcy until 1996, Jack may be able to write off in 1995 the amount paid ($10,000) as a business bad debt. If he can establish that he tried to collect the $10,000 from Ligustrum in 1995 and failed, and that he has no reasonable expectation of recovering it, he will be allowed a deduction. The fact that the taxpayer has paid an amount to a third party because the debtor has defaulted does not relieve the taxpayer of the burden of proving that his loan to the debtor (in the form of the guarantee payment) is worthless.

In addition, again based on Jack's collection efforts, it is possible that a bad debt deduction could be sustained for the $4,000 account receivable due from Ligustrum's Plants. Jack may be able to substantiate the receivable as being worthless in 1995 because of the need for him to perform as a guarantor on the Ligustrum credit line and Ligustrum's deteriorating financial condition leading to the possible filing of bankruptcy in the following year.

Conclusion

Jack Greenthum may be able to take a business bad debt deduction in 1995 for part or all of the $12,000 account receivable due from Jasmine's Ground Covers and $4,000 due from Ligustrum's Plants, provided he can substantiate that the debtors do not have the ability to pay the debt. If the effort and usual means of collection were not completed in 1995, a deduction should not be claimed.

In order to deduct the $10,000 payment on the guaranteed loan of Ligustrum's Plants as a business bad debt, Jack must be able to establish that it became worthless in 1995. A proximate relationship exists between the creation of the guaranteed debt and Jack's nursery business because Ligustrum's Plants is Bloomin Deals' largest customer. Jack's guarantee would be viewed as an attempt to retain his largest customer by helping it avoid financial disaster.

The distinction between a business bad debt and a nonbusiness bad debt is important. A business bad debt is deductible as an ordinary deduction in the year incurred, while a nonbusiness bad debt is treated as a short-term capital loss. Thus, a business bad debt deduction can reduce a taxpayer's trade or business income dollar for dollar and produce (or add to) a net operating loss. Alternatively, a nonbusiness bad debt is of limited benefit because of the limitations on capital losses. The maximum amount of a net short-term capital loss that an individual can deduct against ordinary income in any year is $3,000. In addition, no deduction is allowed for a partially worthless nonbusiness bad debt.

Forms, Elections and Implementation

For each bad debt claimed, a statement should be attached to the return that contains:

1. A description of the debt, including the amount and date it became due;

2. The name of the debtor, and any business or family relationship between the taxpayer and the debtor;

3. The efforts made to collect the debt; and

4. The facts used to determine the debt was worthless (bankruptcy of debtor, or collection efforts and results).
COPYRIGHT 1996 American Institute of CPA's
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Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Jul 1, 1996
Words:1897
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