An area I have seen the IRS audit multiple times recently are bad debt deductions claimed on federal income tax returns under IRC § 166. This section provides a deduction for “any debt which becomes worthless within the taxable year.”[1]
How a bad debt may arise. A typical example of a bad debt deduction is where the taxpayer makes a loan to a third party (preferably a business loan for reasons we will discuss later involving capital loss and carry back of loss) and the debt becomes uncollectable, often due to insolvency, bankruptcy or other inability of the borrower to repay the debt. The taxpayer then claims the deduction on his or her tax return for the uncollectable bad debt.
Audit of bad debt deduction. At that point, insult may be added to injury if the IRS audits and then denies the bad debt deduction. Not only does the taxpayer lose out on repayment, but the taxpayer must undertake the stress and expense of an audit and face the potential denial of the tax deduction or its delay to a future year. Thus, it is critical that the taxpayer and tax professional carefully examine the grounds for claiming the bad debt deduction and adequately document and prepare for this deduction. By doing so at the outset, the taxpayer will be prepared in the event the bad debt deduction is audited.
Bad debt deduction issues. In order to claim the bad debt deduction and in the event of a tax audit, a taxpayer must be prepared to prove they are entitled to the deduction. To do this, the taxpayer must establish the following:
- the bad debt is a bona fide debt;
- the debt is worthless, in whole or in part; and
- whether the debt is business or nonbusiness.
In following articles, we will discuss how the taxpayer can demonstrate these items in order to claim the bad debt deduction and defend against an audit by the IRS.
Practice point. Taxpayers facing a potential uncollectable debt are encouraged to discuss the matter with their tax professional or Jared Le Fevre to determine if the deduction is permitted or to defend against an audit of the bad debt deduction.
About the Author. Jared M. Le Fevre is a Partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal, state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.
Acknowledgment. Jared Le Fevre acknowledges with gratitude the assistance of Lacy Fortin, esq., in researching and preparing this article.
[1] IRC § 166(a).