Claiming a partial bad debt deduction—benefits and conditions

Executive summary: Claiming a partial bad debt deduction

Many businesses hold debts that are partially uncollectible, particularly in current economic conditions. The creditor should consider whether it can claim a partial bad debt deduction. A partial bad debt deduction can enable the creditor to accelerate a future tax deduction on worthless debt instead of waiting for it to become entirely worthless. It also can enable the creditor to lock in the loss as ordinary in character, as opposed to possible future capital loss treatment.

Partial bad debt deduction—when is it available?

A business that holds a debt that is partially uncollectible is sometimes entitled to a partial bad debt deduction prior to the debt becoming totally worthless, under section 166(a)(2) of the Tax Code. A partial bad debt deduction can provide significant tax advantages relating to both the timing and character of the deduction:

• Timing: The creditor (debt holder) can claim a partial deduction in the year that the debt became partially worthless, instead of waiting until the year in which the debt becomes wholly worthless to take the deduction.
• Character: Under section 166, a business’s bad debt deduction generally is ordinary in character. This ordinary deduction can be used to offset ordinary income. If no bad debt deduction is claimed until the debt is partially repaid, the resulting loss generally would be capital in character,¹ in which case the loss cannot offset ordinary income.

Example: Business ABC sells widgets to its many customers, one of which is Business XYZ. XYZ owes $20 million to ABC for widgets purchased by XYZ. In 2024, XYZ becomes insolvent and files for bankruptcy, and its owner leaves the country. As of the end of 2024, the only asset XYZ still holds is its remaining inventory, valued at $5 million. It is evident that ABC will not be able to collect the full $20 million; at best it will only be able to collect from XYZ’s remaining inventory assets. Accordingly, ABC may be eligible to take a $15 million partial debt deduction on its 2024 tax return.

When is a partial bad debt deduction available?

For a creditor to claim a partial bad debt deduction, five conditions must be met:

1. The creditor must hold a debt instrument.
2. The debt must not be a “security.”
3. The debt must be partially worthless.
4. The creditor must charge off the debt on the creditor’s books for the taxable year of the deduction.
5. The debt must be a business debt (unless the creditor is a corporation).²

Before we discuss each of these conditions below, we note that certain financial companies are eligible to apply a different set of bad debt deduction rules. For those companies, proposed regulations published in December 2023 may provide greater certainty and simplicity in determining the timing of bad debt deductions. For further discussion of these proposed regulations, please read our article Bad debt tax deduction method proposed for financial institutions.

1. The creditor must hold a debt instrument

In order to qualify for a bad debt deduction, the debt must be a “bona fide debt,” and not equity or some other type of asset. A bona fide debt is “a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money."³ While the Tax Code permits deductions for partially worthless bad debt, deductions for partially worthless stock and securities are not authorized. Stock and securities can give rise to loss deductions if they become wholly worthless.⁴

The distinction between debt and equity for tax purposes generally depends on multiple factors provided by numerous court decisions addressing the issue. There is no bright-line test for debt characterization. Some of the many factors courts point to include (i) a fixed maturity date, (ii) creditor’s rights, (iii) creditworthiness, and (iv) capitalization of the debtor. A summary of the factors can be found in these articles: Tax Court denies bad debt deduction holding advances were equity and Tax Court once again denies related party bad debt deduction.

2. The debt must not be a security

Debt that is classified as a “security” is not eligible for a partial bad debt deduction. A creditor holding a security may be able to obtain a worthless security deduction under section 165(g), but only if and when the security becomes wholly worthless.

A “security” is defined for this purpose as:

a. a share of stock in a corporation;

b. a right to subscribe for, or to receive, a share of stock in a corporation; or

c. a bond, debenture, note, certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.⁵

3. The debt must be partially worthless

A creditor may not take a bad debt deduction unless the debt is at least partially worthless. The term “partially worthless” isn’t defined in the Tax Code, but some type of identifiable event evidencing worthlessness is necessary to demonstrate worthlessness. A temporary decrease in the debt’s fair market value (FMV) is insufficient. Examples of identifiable events may include:

• Insolvency or bankruptcy of the debtor,
• The debtor’s refusal to pay the debt,
• Sale of the debtor’s business,
• Sustained losses by the debtor,
• A significant decline in the value of the assets securing the debt,⁶
• The death of the debtor, with insufficient assets within the estate to pay the debt,⁷ and
• Events of default

For worthlessness to occur, the facts and circumstances should provide reasonable grounds for abandoning hope of future recovery on that portion of the debt.⁸

To demonstrate a decline in the debt’s value during the year in which the taxpayer desires to take the deduction, the creditor should ensure to document the specific factors that occurred that indicate partial worthlessness.

4. The creditor must charge off the debt on its books for the taxable year of the deduction

A creditor may only take a partial bad-debt deduction if the creditor charges off the debt on its books. The regulations add that a partial deduction may only be taken if it relates to specific debts; the corresponding charge-off must arise from the specific bad debt, not simply an increase in a general reserve account.⁹

A reserve or a contra-account that is credited with respect to a specific debt can qualify as a charge-off for purposes of section 166(a)(2).¹⁰ A charge-off in connection with closing the books for a taxable year should be considered a charge-off within that taxable year for the purposes of this rule.¹¹  Case law provides support for claiming a partially worthless debt deduction in situations where a debt becomes partially worthless in a taxable year and the taxpayer recorded a partial charge-off of the debt in the preceding taxable year.¹²

5. The debt must be a business debt if the creditor is not a corporation

For noncorporate creditors, a partial bad debt deduction can only arise from a business debt; a noncorporate creditor may not take a partial bad debt deduction if the debt is nonbusiness debt. A business debt is (i) a debt created or acquired in connection with a trade or business of the taxpayer, or (ii) a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.¹³

The business debt versus nonbusiness debt distinction is thus an important distinction for noncorporate creditors. Another important ramification of the distinction between the two is that bad debt deductions for nonbusiness debts are capital (and not ordinary) in nature for non-corporate taxpayers.¹⁴

A creditor that is a corporation, however, can take a partial bad debt deduction even if the debt is a nonbusiness debt. The IRS has ruled that an S corporation is treated as a noncorporate taxpayer for purposes of this rule, and is not allowed to claim a partial bad debt deduction for nonbusiness debt.¹⁵

Claiming a partial bad debt deduction

A taxpayer creditor may not claim a bad debt deduction in excess of the taxpayer’s adjusted basis in the debt instrument. When the taxpayer claims the deduction, the taxpayer must reduce its basis in debt by the amount deducted, which serves to limit future bad debt deductions (or to decrease a future loss or increase a future gain if the debt is ultimately repaid in whole or in part).

Taxpayers should document their attempts to collect a debt, as some courts have held that a creditor must exhaust available reasonable means of collection (if any) before taking a deduction.¹⁶ If the IRS later questions the deduction, collection efforts can provide evidence that the debt was uncollectible.

There is sometimes no single identifying event that indicates partial worthlessness, but instead a gradual shift in the creditor’s ability to collect a debt. Due to the inherent uncertainty surrounding the year that a debt became partially or wholly worthless, the usual three-year statute of limitations on refund claims is in some bad debt deduction situations extended to seven years.¹⁷

Summary

A partial bad debt deduction can provide significant tax savings to creditors, by enabling both the acceleration of a tax deduction and a deduction with ordinary character rather than a capital loss. The deduction may only be taken if several requirements are met. Because it is often unclear whether a debt has become partially worthless, it is; important to consider various factors to holistically determine if a situation qualifies for the deduction. Taxpayers seeking a partial bad debt deduction should consult with their tax advisors, and should also document the factors that support worthlessness before claiming the deduction.

^{_{[1] See section 1271(a).}}

^{_{[2] See section 166 and Reg. section 1.166-3.}}

^{_{[3] Reg. section 1.166-1(c).}}

^{_{[4] See section 165(g).}}

^{_{[5] Section 165(g)(2) provides the applicable definition of “security.” Other definitions of “security” or “securities” are applicable for certain other federal tax purposes; they are not discussed here.}} 

^{_{[6] See, e.g., Murchison National Bank v. Grissom, 50 F.2d 1056 (4th Cir. 1931).}}

^{_{[7] See, e.g., Magnus, Mabee & Reynard, Inc. v. Comm’r, 1 B.T.A 907 (1925).}}

^{_{[8] See, e.g., Newman v. Comm’r, T.C. Memo 1982-61.}}

^{_{[9] See Reg. section 1.166-3}}

^{_{[10] See Brandtjen & Kluge, Inc. v. Comm’r, 34 T.C. 416 (1960), acq. 1960-2 C.B. 4. See also Hammerschmidt v. Comm’r, 12 B.T.A. 811 (1928).}}

^{_{[11] See Brandtjen & Kluge, 34 T.C. 416.}}

^{_{[12] See Mason Machine Works v. Comm’r, 3 B.T.A. 745 (1926), acq. 1927-1 C.B. 4; First National Bank of Los Angeles v. Comm’r, 6 B.T.A 850 (1927). See also Reg. section 1.166-3(a)(2) (a taxpayer who charges off a debt but is disallowed a deduction for the same year can claim the deduction in a later year without additional charge offs).}}

^{_{[13] Section 166(d)(2).}}

^{_{[14] Section 166(d)(1)(B).}}

^{_{[15] Rev. Rul. 93-36, 1993-1 C.B. 187.}}

^{_{[16] See, e.g., Newman v. Comm’r, T.C. Memo 1982-61.}}

^{_{[17] See section 6511(d).}}