A debt is something that is owed or due. In a business context, a debt can take several forms, from accounts receivable (A/R) to the “buy now pay later” option (BNPL) for customers, to loans made by the business to owners, employees, or others. Some debts are short term, others long term. Some may be secured while others are not. From a tax perspective, unpaid debts may give rise to a write-off…or not.
A/R and BNPL
Accounts receivable and buy-now-pay-later are really financing arrangements for your customers or clients to get what you’re selling now with the ability to pay later. Usually, these arrangements don’t entail any financing charges (e.g., fees, interest).
From a tax perspective, the ability to deduct an unpaid A/R or other loan depends on your accounting method. Those on the accrual basis—rather unusual for small businesses—can deduct unpaid receivables. Those on the cash method cannot take a deduction, even though they’ve expended time and energy on a sale. As the IRS says, “to deduct a bad debt, you must have previously included the amount in your income or loaned out your cash.” This means cash basis businesses can’t deduct unpaid fees, rents, or other similar items of taxable income. If you don’t receive payment for goods, you can adjust your inventory. But the value of your labor isn’t deductible. I’ve done legal work for a client who stiffed me; it doesn’t feel good and there’s no tax relief for this wrong.
Advances and loans
A small business isn’t a lender but may find itself in the position of lending money from time to time. This can be in the form of an advance, which is really just a short-term loan. Or it can be a long-term arrangement.
Loans from a business to its owners are particularly suspect from the IRS’s point of view, so be sure that all factors indicating that the arrangement is really a loan and not compensation or other type of payment. An appellate court, in reviewing loans by a corporation, developed a list of 11 factors used to determine whether a transaction is bona fide loan:
- The names given to the certificates (promissory notes) evidencing the indebtedness
- The presence or absence of a maturity date
- The source of the payments
- The right to enforce payment of principal and interest
- Participation and management
- A status equal to or inferior to that of regular corporate creditors
- The intent of the parties
- “Thin” or adequate capitalization
- Identity of interest between creditor and stockholder
- Payment of interest only out of “dividend” money
- The ability of the corporation to obtain loans from outside lending institutions
As an example, a recent Tax Court decision found that advances made by Anaheim Arena Management, LLC were not bona fide debts because there were no enforceable contracts for repayment.
What to do: At a minimum, when making a loan be sure to have a promissory note detailing the terms of the loan: when interest is due, a schedule of payments, and what happens in the event of a default. Create a promissory note using free templates, such as those from eForms, LawDepot, and PromissoryNote. Also treat the loan as such on the business’ balance sheet. And, if there is a default, be sure to follow through on collections.
Business versus nonbusiness bad debt. The tax treatment of unpaid debts depends on whether they are characterized as business or non-business. Business bad debts include:
- Loans to clients, suppliers, distributors, and employees
- Credit sales to customers, or
- Business loan guarantees
All loans that are not business loans are nonbusiness loans. Loans to owner-employees (S corporation shareholders) are nonbusiness loans if the predominant motive for the loan was protecting their investment in the corporation. They’re business loans if made to protect their salary. It’s all a question of facts and circumstances.
Business loans are deductible from business income when they are partially or wholly worthless. Nonbusiness bad debt must be wholly worthless to be deductible, and then the loss is treated as a short-term capital loss.
Final thought
As I always say, an outstanding A/R or other debt owed to a business isn’t fine wine and doesn’t get better with age. When amounts owed to you become delinquent, be proactive in collection activities. Don’t be shy in asking for immediate payment (by phone, email, or snail mail). Consider using a collection agency or attorney if the amount outstanding warrants this course of action. And think about going to your local small claims court to get what you’re owed. Yes, you may get a tax deduction for loans gone bad, but cash in hand from repayment is much better!
