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Publication 535

How To Claim a Business Bad Debt(p41)

There are two methods to claim a business bad debt. Generally, you must use the specific charge-off method. However, you may use the nonaccrual-experience method if you meet the requirements discussed later under Nonaccrual-Experience Method.

Specific Charge-Off Method(p41)

If you use the specific charge-off method, you can deduct specific business bad debts that become either partly or totally worthless during the tax year. However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the year.

Partly worthless debts.(p41)

You can deduct specific bad debts that become partly uncollectible during the tax year. Your tax deduction is limited to the amount you charge off on your books during the year. You do not have to charge off and deduct your partly worthless debts annually. You can delay the charge off until a later year. However, you can’t deduct any part of a debt after the year it becomes totally worthless.
Significantly modified debt.(p41)
An exception to the charge-off rule exists for debt which has been significantly modified and on which the holder recognized gain. For more information, see Regulations section 1.166-3(a)(3).
Deduction disallowed.(p41)
Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. If, under audit, the IRS does not allow your deduction and the debt becomes partly worthless in a later tax year, you can deduct the amount you charged off in that year plus the disallowed amount charged off in the earlier year. The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year.

Totally worthless debts.(p41)

If a debt becomes totally worthless in the current tax year, you can deduct the entire amount minus any amount deducted in an earlier tax year when the debt was only partly worthless.
You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. However, you may want to do so. If you do not and the IRS later rules the debt is only partly worthless, you will not be allowed a deduction for the debt in that tax year because a deduction of a partly worthless bad debt is limited to the amount actually charged off. See Partly worthless debts, earlier.

Filing a claim for refund.(p41)

If you didn’t deduct a bad debt on your original return for the year it became worthless, you can file a claim for a credit or refund. If the bad debt was totally worthless, you must file the claim by the later of the following dates.
If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates. You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. Such an impairment requires proof of existence.
For details and more information about filing a claim, see Pub. 556. Use one of the following forms to file a claim. For more information, see the instructions for the applicable form.

Table 10-1. Forms Used To File a

IF you filed as a...THEN file...
sole proprietor or farmerForm 1040X.
corporationForm 1120X.
S corporationForm 1120S and check box H(4).
partnershipForm 1065X if filing on paper or
Form 1065 and check box G(5) if filing electronically.

Nonaccrual-Experience Method(p41)

If you use an accrual method of accounting and qualify under the rules explained in this section, you can use the nonaccrual-experience method for bad debts. Under this method, you do not accrue service-related income you expect to be uncollectible. Because the expected uncollectible amounts are not included in income, these amounts are not later deducted from income.
Generally, you can use the nonaccrual-experience method for accounts receivable for services you performed only if:

Service-related income.(p41)

You can use the nonaccrual-experience method only for amounts earned by performing services. You can’t use this method for amounts owed to you from activities such as lending money, selling goods, or acquiring receivables or other rights to receive payment.

Gross receipts test.(p41)

To find out if you meet the $5 million gross receipts test for all prior years, you must figure the average annual gross receipts for each prior year. If your average annual gross receipts for any year exceeds $5 million, you can’t use the nonaccrual-experience method.
The average annual gross receipts for any year is the average of gross receipts from the year in question and the 2 previous years. For example, if you were figuring the average annual gross receipts for 2017, you would average your gross receipts for 2015, 2016, and 2017.

Interest or penalty charged.(p41)

Generally, you can’t use the nonaccrual-experience method for amounts due on which you charge interest or a late payment penalty. However, do not treat a discount offered for early payment as the charging of interest or a penalty if both the following apply.

Change in accounting method.(p41)

Generally, you must obtain consent to change to a nonaccrual-experience method (other than one of the safe harbor methods) or to change from one method to another. See Form 3115 and its instructions for more information and exceptions.