The economic downturn affected different businesses in different ways. For industries that involved credit or account-based billing, one of the difficulties faced was a greater number of debts that could not be collected. Some businesses might be faced with the reality that some money will never be paid, and the debt is therefore worthless. However, this doesn’t have to be total loss; the IRS allows a part of those debts to be considered deductions on your annual return.
There are a few important points to remember when it comes to claiming these deductions:
- You will not be claiming the entirety of the worthless debt, but the adjusted basis in the receivable.
- You need to provide evidence that the debt is legitimate.
- You must establish certainty that the debt cannot be collected. In other words, you made a reasonable effort to collect the debt but were unsuccessful. This does not necessarily require the services of collectors or legal action.
Deductions must be claimed within the year during which the debts were incurred, even if the business decides the debt was worthless during a later year. In some cases, this will mean filing to amend a prior year’s return to include the new deduction.
Debts may be deemed partially or totally worthless, which changes the statute for how long the business has to amend their past return and include the deduction. For the former, the business is allowed either, two years from the time the tax was paid or three years after the return was filed (including extensions), whichever is later. For totally worthless debt, the time after the tax is paid remains at two years, but the time after the return is filed is longer—seven years without extensions included—and again, this is whichever occurs later.