If you are in business long enough, you will be stiffed by a deadbeat. The resulting bad debt may or may not be a tax-deductible item. Read on. (The full rule is in the tax code and regulations, IRC § 166, Reg. 1.166.)

Business Bad Debt Rules

Let’s get the bad news out of the way first: If you sell your services, you cannot deduct an unpaid bill as a bad debt. No tax deduction is allowed for time you devoted to the client or customer who doesn’t pay. The tax code rationale is that if you could deduct the value of unpaid services, it would be too easy to inflate your bills and claim large bad debt deductions-and too hard for the IRS to catch you. If your business provides goods, however, you can deduct the costs of any goods sold, but not paid for, as an ordinary business expense. You cannot deduct any lost profits you would have collected from the sale. The same rule holds if you actually lose dollars. For instance, say you made a loan to a customer or client and didn’t get paid back. To get the deduction, there must have been a business-not personal-reason for making the loan. And, you must have taken reasonable steps to collect the debt-such as making a written demand for payment, going to court or turning the debt over to a collection agency. Example: In 1997, Ralph and Rhonda’s incorporated print shop made a $2,000 loan to Susan, a friend and good customer, to keep her florist business afloat. Despite this help, Susan went into bankruptcy in 1998 before making any repayment. Result: As long as Ralph and Rhonda’s corporation made the loan to protect their business relationship-and not just to help a friend-the bad debt is deductible for the corporation in 1998.

Personal Bad Debt Rules

There are different tax rules for “non-business” bad debts-ones that don’t qualify as business expenses. A bad debt in your personal life can still produce a tax benefit, but under the much more restrictive short-term capital loss rules for individuals. Generally, this means that a bad debt can be claimed on your personal tax return first to offset any capital gains on investments-and then up to another $3,000 max to offset your “ordinary” income from earnings. To claim a non-business bad debt deduction, file Schedule D, Capital Gains and Losses, with your tax return. A loan to Uncle Festus falls into this category, but not if it was really a gift to get him into alcohol rehab and you never expected to get the money back. To bulletproof the deduction, get a signed promissory note from Festus. Next be ready to show the IRS you made some written efforts to try to collect on it. Expect an auditor to be suspicious if a relative is involved in the tax deduction, unless you qualify to claim old Festus as a dependent.

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Q & A: Business & Finance Law