This course is the first course in a five-course US Federal Tax Specialization. It covers and focuses on the U.S. federal tax system as it relates to individuals, employees, and sole proprietors. Key concepts covered include gross income and items that are statutorily included or excluded in it, personal and business expenses that qualify as tax deductions, and the differing tax treatments for employees versus self-employed taxpayers. Unlike many other introductory courses in tax and as part of this course’s comprehensive wrap-up, learners will be provided with practical and tangible experience reporting both income and expenses on the main individual tax return used in the US, Form 1040. If you have enjoyed this course, consider enrolling in our online graduate Accounting program. The University of Illinois at Urbana-Champaign, consistently ranked as one of the nation's top three accounting programs, now offers a master’s in accounting at a very affordable tuition rate and is completely online. The iMSA is a full Master of Accountancy program and students graduate with an MS that is highly recognized. Try an open course or two, then apply for admission into the credit-bearing version as you may be eligible to take credit-bearing courses during the application process. If you are missing any prerequisites for the full degree, you can complete Coursera courses to demonstrate readiness and strengthen your application for the iMSA. For more information on this exciting iMSA online program, refer to this link: https://www.coursera.org/degrees/imsa
Business Expenses: Bad Debts
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From the course by University of Illinois at Urbana-Champaign
Federal Taxation I: Individuals, Employees, and Sole Proprietors
56 оценки
University of Illinois at Urbana-Champaign
56 оценки
Course 1 of 5 in the Specialization U.S. Federal Taxation
From the lesson
MODULE 6: DEDUCTIONS AND LOSSES: ITEMIZED VS BUSINESS
In this module, we turn our focus to expenses that qualify as from AGI deductions, also known as itemized deductions. We will wrap up the module by discussing some unique situations where deduction treatment is an exception to the general rules, such as losses on securities or the artificial deduction of the Domestic Production and Activities Deduction (DPAD), both of which are actually allowed to be taken as for AGI deductions.
Meet the Instructors
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
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Welcome back, in the last few videos we've been examining itemized deductions.
And specifically itemized deductions of a personal nature, for
example home mortgage interest, charitable contributions, state and
local taxes paid, and casualty and theft losses.
For the most part, these deductions have been classified as from AGI.
In this video, we'll switch gears and
start looking at business-related deductions.
The key difference between personal-type and business-type deductions
is that business-type deductions are classified as for
AGI deductions rather than from AGI deductions.
Examples include business bad debts, the domestic production activities deduction,
net operating losses, and worthless securities.
In this video, we'll begin looking at this list and start with business bad debts.
First of all, what are business bad debts?
Well if I'm a business owner and
I make a sale to a customer, the customer can either pay me in cash now, or
on account or on credit, which means I'll collect the cash at some point later.
If a customer pays on account, to me as a business owner it'll be classified as
an asset, specifically as an accounts receivable.
Now if an account receivable arising from the credit sale of goods
becomes worthless, then a bad debt deduction is permitted
only if income arising from the receivable was previously included in income.
This'll happen if a business owner follows the accrual method, that is recognize
the income once the income is earned, not necessarily when cash is received.
Because an accrual basis taxpayer recognizes the income
within accounts receivable, he or she will have to pay tax on that income.
But if no cash is ever collected, it would seem unfair for
the business owner to continue recognizing the income and
paying tax on the income if cash was never received.
Therefore to the extent the business owner recorded income due to the credit sale,
then not ultimately collecting the cash from the customer,
will result in a bad debt deduction.
The deduction will essentially reverse out the previous recognition of income
of the account receivable.
And so for the business owner, this deduction will be for AGI.
If however, the business owner uses the cash method of accounting,
there's no income recognized on the credit sale because the cash method
taxpayers recognize income when cash is received or constructively received.
Therefore, with a credit sale for
a cash basis business owner, there's no need for a bad debt deduction,
since there was no income previously recognized from the sale.
In order to deduct a bad debt, the specific charge-off method must be used.
That is, the business owner must identify the specific customer and
determine that the customer will not pay.
Perhaps the business owner keep sending the customer invoices and bills, but
the customer just doesn't pay.
At this point, the business owner can identify the specific account to be
written off and can do so.
What is not allowed is for the business owner to estimate how much of his or
her credit sales will go uncollected, then deduct that estimate.
Recall from a previous video that deductions for estimates or
reserves are not allowed.
The deduction is only available when a specific known amount is written off.
Furthermore, the deduction occurs in the year when the debt is partially or
wholly worthless.
In other words, the business owner might collect half of the money
owed by the customer, but not the other half.
The half that wasn't collected can still be written
off if the business owner decides that the customer simply won't pay that half.
Similarly if the customer doesn't pay any of the bill,
the business owner can deduct the entire account receivable as worthless.
Note that if a debt that was previously deducted as partially worthless
becomes totally worthless in a future year,
only the remainder not previously deducted can be deducted in the future year.
Finally, in a case of total worthlessness, the deduction is allowed for
the entire amount in the year it becomes worthless.
The next question is how much can the business owner deduct?
Here, the deductible amount depends on the basis in the bad debt.
That is, what's the kind of ownership stake or
the capital that the business owner is entitled to in the account receivable?
Here, if the debt is from a sale of services or goods and
the face amount was previously included in income, then that amount is deductible.
For example, if I sell a customer $100 worth of goods and
the customer doesn't pay me,
then I can write off the basis that I have in the accounts receivable or $100.
Here I've established basis in the account receivable because I've recognized income
and paid tax on it.
Generally speaking, taxpayers establish basis when they purchase something or
pay tax on something.
Here I would be paying tax on the income recognized from the credit sale.
Therefore, I would have basis in the account receivable,
which can then be written off.
If however, the taxpayer purchased the debt,
then the deduction is equal to the amount paid for the debt instrument.
For example, let's say that my business is to buy the accounts receivables
from hospitals at a discount,
and then track down the patients that owe money so they pay.
So my business model is to acquire the hospital's receivables and
keep for myself any payments from patients that exceed the invested capital.
In such a transaction, the hospital is willing to sell me its receivables,
even at a discount, because they would rather have some or
most of the cash today than deal with tracking down delinquent patients and
trying to have them pay, and perhaps some not pay.
So, if I pay $10,000 to purchase $15,000 of the hospital's receivables and
then I can not collect the $15,000, then my deduction is limited only
to the $10,000 capital that I invested to purchase the receivables.
If the receivable has been written off, but then I do end up collecting it,
then I have to re-recognize that payment in gross income.
That is, I'm trying to reverse out the reversal.
When I made the credit sale originally, I recognized the income, but
then if I didn't collect the cash,
I reversed out the income recognition by claiming the bad debt deduction.
But if I actually do collect the cash, then it turns out the receivable
wasn't bad, and thus I still need to recognize the related income.
So let's do a quick logic check here.
So Rick's in the business of purchasing accounts receivable.
Last year he bought an accounts receivable with a face value of $80,000 for $60,000.
During the current year, Rick settled the account, receiving $56,000.
So what's the maximum amount of the bad debt deduction that Rick can take for
the current year?
So here, Rick's basis in the purchase receivables is $60,000, not $80,000.
So if he collects only $56,000 of the $60,000 he paid for
the receivables, his loss is $4,000.
His loss is not the difference between the face value of the receivables and
what he collected.
So his loss is not the $24,000 difference between 80,000 and 56,000.
Now let's look at nonbusiness bad debts.
These are bad debts unrelated to a taxpayer's trade or business.
You can think of these as personal loans between individuals.
Maybe I lend a friend $1,000, and my friend doesn't pay me back.
This is a nonbusiness bad debt.
Here my deduction would be a short-term capital loss in the year that the amount
is deemed worthless with certainty.
In fact, no deduction is allowed for
partial worthlessness of a nonbusiness bad debt.
The debt must be completely worthless.
So what the suggests if that is my friend owes me $1,000, it's probably better for
the debt to be deemed completely worthless so that I can take the $1,000 deduction.
At least here my tax benefit will be $1,000 times my marginal tax rate.
But if my friend pays me back say $100,
I have a $900 nonbusiness bad debt, but I can't deduct it.
So here I'm actually worse off from an after tax perspective
if I get a small payment from my friend and
no deduction than no payment from my friend and a full deduction.
Here, because the deduction is characterized as a short-term capital
loss, it means the taxpayer can claim a deduction up to $3,000
to the extent capital losses exceed capital gains.
If the loss exceeds $3,000 for the year, the taxpayer can carry forward
the loss and apply it to future year's capital gains or if there aren't any,
take another $3,000 loss on the next year's tax return and
do the same year after year until the full nonbusiness bad debt is deducted.
Now one concern that the IRS has with bad debts is that, for example,
I'm going to give my brother $1,000, but instead of classifying it as a gift,
I'll just classify it as a loan.
So although I won't be expecting anything in return from my brother for
the $1,000 amount, for tax purposes I'll pretend it's a loan.
I'll pretend it's entirely worthless, and
then deduct the entire amount as a capital loss.
The IRS is worried about these kinds of fake transactions
that generate deductions.
So we'll be very suspicious of loans made between related parties, for example,
between family members or between a shareholder and a corporation that
the shareholder owns, or between a partner and a partnership that the partner owns.
Here generally the movement of money is considered a gift, a non-deductible gift,
and not a bad debt that might benefit from deduction treatments.
Now of course there could be circumstances where related parties will lend or
need to lend each other money.
So if this happens, then there should be a bona fide debtor, creditor relationship
which means there's a valid enforceable contract to pay a fixed or
determinable sum of money over a specific time.
So back to my example with lending my brother $1,000.
If I draw up a contract that he'll pay me back $1,000 with 5% interest
paid monthly over the next 24 months and we have the contract notarized,
then this is a bona fide debtor creditor relationship, and
thus my brother will have to pay me back all the funds.
In this case, the $1,000 will not be a disguised gift to my brother.
He must pay me back and
if he doesn't pay anything back, only then can I deduct the bad debt.
Here's another example of a related party transaction involving bad debts.
Here we have Timmy, he loans $2,000 to his aunt for an operation.
Timmy's aunt owns no property and is not employed, and
her only income consists of social security benefits.
No note is issued for the loan, no provision for interest is made, and
no repayment date is mentioned.
In the current year Timmy's aunt dies, leaving no estate.
Assuming the loan is unpaid, can Timmy take a deduction for the loan?
Well in this case, Timmy cannot take the deduction because no bona fide
debtor-creditor relationship was established.
There was no contract, no interest rate, and no repayment schedule.
Therefore the $2,000 Timmy gave his aunt would be considered a gift by the IRS,
and so Timmy would not be able to claim a nonbusiness bad debt deduction.
To recap, in this video we examined bad debt deductions.
Business bad debt deductions are allowed for accrual basis taxpayers and
would be deductible for AGI for sole proprietor business owners.
Nonbusiness bad debts are allowed for individuals, but
only if the loan is completely worthless.
Here the loss is classified as a short-term capital loss and
is deductible for AGI, but the loss amount is limited.
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