When is partial worthlessness of debt allowed

These allowable losses would be capital losses because the underlying investments are capital assets in the hands of Corporation A. Example 4: Assume the same facts as Example 3, but that Corporation A is a bank.

Consequently, its gain or loss resulting from the investment in the Corporation B bonds is ordinary rather than capital Sec. Conclusion: Corporation A is entitled to the same deductions as those determined in the conclusion to Example 3, but each of the losses is a bad debt deduction, as opposed to a mark-to-market loss, under the ordering rule of Prop. These deductions are ordinary in character. This is the same result as Example 2. However, unlike the conclusion in Example 2, these deductions are allowed regardless of whether the losses resulted from credit quality issues or from other market-driven fluctuations in the value of the bonds including interest rate fluctuations.

A decline in the value of investment securities has caused many taxpayers to suffer economic losses in recent years. Moreover, while taxpayers continue to hold these securities, their opportunity to claim a current deduction for these losses is limited. Certain taxpayers, such as banks, enjoy more liberal rules for claiming current deductions, but most taxpayers will have to defer the loss deductions until the securities are sold or become completely worthless.

For certain taxpayers that are able to meet the definition of a dealer in securities under Sec. Editor Notes. Frank J. For additional information about these items, contact Mr.

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Editor: Frank J. Latest News. Latest Document Summaries. Featured Articles. Most Read. Tax Insider Articles. The debt had no tax basis, so no deduction is allowed. Business entities that use the accrual method of accounting for tax purposes can generally deduct a bad debt loss in the year when worthlessness is established. For example, Company B uses the accrual method of accounting for tax purposes. Assuming the debt in question is a business debt that has tax basis, a portion of the basis can be deducted in the year when the debt becomes partially worthless.

However, the taxpayer must show that partial worthlessness has occurred, and it must disclose the amount that has been charged off on its books. Alternatively, the taxpayer can deduct the entire debt in the tax year when it becomes wholly worthless. In the event of an audit, the IRS may take the position that worthlessness occurred in a year earlier than the year in which the bad debt deduction was claimed. To protect taxpayers from losing righteous bad debt deductions because the statute of limitations for amending returns has expired, a special tax code provision extends the statute of limitations for claiming bad debt deductions from the standard three years to seven years.

If it later becomes clear that the deduction should have been claimed in a later year, an amended return can be filed for the earlier year. For a bad debt, you must show that at the time of the transaction you intended to make a loan and not a gift. If you lend money to a relative or friend with the understanding the relative or friend may not repay it, you must consider it as a gift and not as a loan, and you may not deduct it as a bad debt.

Business Bad Debts - Generally, a business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless.

A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. A business deducts its bad debts, in full or in part, from gross income when figuring its taxable income. For more information on methods of claiming business bad debts, refer to Publication , Business Expenses. Nonbusiness Bad Debts - All other bad debts are nonbusiness. Nonbusiness bad debts must be totally worthless to be deductible. The income would have been booked at the time of the sale since W is an accrual - method business.

Worthlessness can be established when the taxpayer sues the debtor, wins a judgment, and then shows the judgment is uncollectible. However, when the surrounding circumstances indicate that a debt is worthless and uncollectible, and that legal action to collect the debt would in all probability not result in collection, proof of these facts is sufficient to justify the deduction Regs.

Evidence that a debtor is experiencing financial difficulties will not by itself support an argument for worthlessness. The debtor's bankruptcy, however, generally does indicate that an unsecured business debt is at least partially worthless Regs.

Thus, retaining a copy of the bankruptcy notice should support at least a partial reduction in the value of a receivable or other noncollateralized debt due from the bankrupt business.

Beyond cessation of the debtor's business or a bankruptcy notice, the courts have accepted the following as proof that a debt's value has declined or become worthless:. Observation: Absent any of these items as proof, a taxpayer's best documentation is likely to be a detailed record of collection efforts. The record should indicate that the business made every effort a reasonable person would take to collect a debt.

However, as noted previously, the taxpayer is not required to actually file a judgment against the debtor if, based on the facts, this action obviously would not improve the collection effort's success. A business bad debt can be either partially or totally worthless. If the taxpayer can collect some, but not all, of the debt, it has a partially worthless debt Sec. If the taxpayer cannot collect any of the remaining amount of a debt, even if it collected some of it in the past, the taxpayer has a totally worthless bad debt Sec.

Before the taxpayer can deduct a partially worthless business debt, it must be able to show that partial worthlessness has occurred and the amount of partial worthlessness that has been charged off on the books of the business. The taxpayer may choose from among the following options concerning how to handle the debt for tax purposes Regs. The taxpayer may treat each partially worthless debt differently. However, in no case may the taxpayer claim a tax deduction any later than the year in which a debt becomes completely worthless.

Example 3. Deducting a partially worthless debt: C owns and operates an accrual - method sole proprietorship selling computer equipment. The customer is having financial problems. Alternately, she may wait until the balance of the debt is either collected or determined to be worthless and claim a bad debt deduction for the entire uncollected amount at that time.

A totally worthless debt is deductible only in the tax year it becomes totally worthless. The deduction for the debt does not include any amount deducted in an earlier year when the debt was only partially worthless Regs. Caution: The business is not required to make an actual charge - off on its books to claim a bad debt deduction for a wholly worthless debt. However, it may want to do so in case the IRS later asserts the debt was only partially worthless and disallows even a partial deduction since no charge - off occurred.

A deduction for a partially worthless debt is limited to the amount actually charged - off on the business's books. Note: It is sometimes difficult to prove that a debt became worthless in a particular year.