Is your business facing challenges in collecting payments from clients or vendors? If so, you might be eligible to claim a business bad debt deduction on your upcoming 2023 tax return. However, to take advantage of this deduction, you need to act promptly and meet specific requirements.
Understanding Business Bad Debt Deductions
To claim a business bad debt deduction, you must demonstrate that you’ve made a “reasonable” effort to collect the debt. While this doesn’t necessarily entail filing a lawsuit against the debtor. It does mean that a single phone call won’t suffice. You should give it your best shot, attempting to collect the debt in earnest. In some instances, a dedicated effort might even result in successfully recovering the debt. However, if all attempts fail, you’ll be in a position to potentially claim a bad debt deduction.
The IRS has specific requirements for claiming a business bad debt deduction:
Inclusion in Gross Income: A cash-basis taxpayer can only claim a business bad debt deduction if the amount owed was previously included in their gross income.
Debt Legitimacy and Irrecoverability: The business must establish that the debt is legitimate and cannot be recovered from the debtor. This underscores the need to make a reasonable effort to collect the outstanding amount.
Differentiating Partially and Totally Worthless Debts
The tax code distinguishes between partially and totally worthless debts, each with its own set of rules:
Partially Worthless Debts: You can deduct the amount charged off on your books. Importantly, you’re not required to charge off and deduct partially worthless debts annually, so you can defer this to a later year. However, you cannot deduct any part of a debt after the year it becomes entirely worthless.
Totally Worthless Debts: If a debt becomes totally worthless during the current tax year, you can deduct the entire amount, less any deductions previously claimed for partially worthless debts.
It’s worth noting that you don’t have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. However, failing to record a charge-off could have consequences if the IRS later determines that the debt is only partially worthless. In such a scenario, you won’t be allowed a deduction for the debt in that tax year. This limitation arises because the deduction of a partially worthless bad debt is restricted to the amount actually charged off.
Taking Action for 2023
If you haven’t already initiated collection efforts but aspire to claim a business bad debt deduction for the 2023 tax year, you need to act swiftly. Begin your collection endeavors through phone and email contacts. If these initial attempts prove unfruitful, consider following up with a series of letters or, in more challenging cases, contemplate the use of a collection agency.
In the event that all your efforts to collect the debt remain unsuccessful, it’s essential to explore the possibility of securing a business bad debt deduction on your 2023 tax return. Engage with the relevant tax authorities to understand the specific procedures and documentation required to support your deduction claim.
In summary, the business bad debt deduction can provide financial relief for businesses struggling to recover outstanding debts. By demonstrating a reasonable collection effort and adhering to the IRS’s guidelines, businesses can optimize their tax situation and potentially recover some of the funds owed to them. Therefore, if you find your business facing collection challenges, don’t hesitate to explore the possibility of a business bad debt deduction as a potential solution to your financial woes.