Income Tax Notes

Exam 2 – Study Guide

Chapter 7

Bad debts

• If an account receivable arising from credit sale of goods or services becomes worthless

– A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income

– No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected

--A bad debt can also result from the nonrepayment of a loan made by the taxpayer or from purchased debt instruments.

Return to the facts of The Big Picture on p. 7-1.

• Martha is a cash basis taxpayer

– She cannot take a bad debt deduction for unpaid accrued interest on the loan to her friend because it was never recognized as income.

Business Bad Debts

• Specific charge-off method must be used

– Exception: Reserve method is allowed for some financial institutions

Deduct as ordinary loss in the year when debt is partially or wholly worthless

• If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year

– Only the remainder not previously deducted can be deducted in the future year

• In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless

• Deductible amount depends on basis in bad debt

– If debt arose from sale of services or products and the face amount was previously included in income

• That amount is deductible

– If the taxpayer purchased the debt

Deduction is equal to amount paid for debt instrument

• If a receivable has been written off

– The collection of the receivable in a later tax year may result in income being recognized

– Income will result if the deduction yielded a tax benefit in the year it was taken

--The loss is deductible only in the year of partial or total worthlessness for business debts and only in the year of total worthlessness for nonbusiness debts.

Nonbusiness Bad Debts

• Nonbusiness bad...