Business Expenses: Bad Debts

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Из курса от партнера University of Illinois at Urbana-Champaign

Federal Taxation I: Individuals, Employees, and Sole Proprietors

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University of Illinois at Urbana-Champaign

Federal Taxation I: Individuals, Employees, and Sole Proprietors

85 оценок

Курс 1 из 5 — Specialization U.S. Federal Taxation

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

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MODULE 6: DEDUCTIONS AND LOSSES: ITEMIZED VS BUSINESS

In this module, we first turn our focus to expenses that qualify as itemized deductions, which are a from AGI deduction. We will also learn about another from AGI deduction, the new 20% deduction for qualified business income, which while a from AGI deduction is not an itemized deduction. And, we will discuss other business deductions such as bad debts and net operating losses. Finally, we'll discuss deductions for losses on worthless securities and certain qualifying small business stock.

Business Expenses: Bad Debts12:30

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Matthew Hutchens
Lecturer of Accountancy
Department of Accountancy
Petro Lisowsky, PhD, CPA
Associate Professor of Accountancy
College of Business: Department of Accountancy

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 interests, 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,

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 am 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 will happen if a business owner follows the accrual method-- that is, recognized

the income once the income is earned, not necessarily when cash is received.

Because an accrual-basis taxpayer recognizes the income with an 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 would 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 keeps 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 the 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 the 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 the 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 hospitals' 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 cannot 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 is 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 purchased 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 non-business 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 non-business 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 non-business bad debt.

The debt must be completely worthless.

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 years' 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 non-business 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 a $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 I'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 the 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 bonafide 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 bonafide debtor-creditor relationship, and thus

my brother will have to pay me back all of 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 bonafide 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.

So Timmy would not be able to claim a non-business 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.

Non-business 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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