The deductibility of a bad debt solely depends on the character of the underlying debt. In the event the bad debt is business related, it is fully deductible by the taxpayer from gross income as an ordinary business expense in the year the debt becomes either partially or completely worthless. If it is partially worthless, only the part of the debt that is not expected to be collected can be deducted.
Non Business Bad Debt
In the event the debt is considered a non business bad debt, it can be deducted for tax purposes only if the debt is completely worthless. The worthlessness of a non business bad debt is always treated as a short term capital loss and is subject to the $3,000 limitation applicable to the deduction for capital losses.
Deducting Business Bad Debts
In contrast, when a taxpayer can demonstrate that a business debt has become completely or partially worthless, the taxpayer can claim a deduction from gross income for the full amount that is not expected to be collected in the future. A business bad debt is:
1. Was created or acquired in connection with the taxpayer’s trade or business; or
2. The worthlessness of which has been incurred in the taxpayer’s trade or business.
Amounts that have been advanced to a corporation in exchange for a bond, debenture, note, or other evidence of the debt are considered to be investments and therefore do not qualify as business debts. This basically means that the partial or total worthlessness of such investments are not deductible as business bad debts.
The same is true for loans that are made by a shareholder to be used by a corporation to pay its debts. These loans are not considered business loans and will not be eligible for deduction according to the previous provisions.