*Originally published in the Fall 2025 edition on the PICPA’s Pennsylvania CPA Journal. View here.
Bad debts can be an unfortunate circumstance for any type of business in any type of industry and in any type of economy. When a customer or debtor fails to pay a liability, the business may need to write off the unpaid amount as bad debt. However, it is not an “all or nothing” proposition, as some bad debts may not be entirely worthless. In some cases, only a portion of the debt is considered uncollectible, while the remainder may still hold value as there is hope it can be collected in the future. These are referred to as partially worthless bad debts. Understanding how to properly manage partially worthless bad debts may offer tax relief both in the character and timing of a deduction and minimize the overall loss for the business.
Bad Debts in General
Internal Revenue Code Section 166 provides for a deduction for bad debts that are both wholly worthless and partially worthless. There are, however, certain criteria that must be met for a taxpayer to claim a bad debt deduction. First, the taxpayer must establish that bona fide debt exists. A bona fide debt is debt that arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.1 When determining if a bona fide debt exists, courts generally look at the intention of the debtor-creditor relationship; the existence of a written, executed agreement establishing the debt with defined terms and a maturity date; and whether there is a reasonable expectation of the debt being repaid, among other factors.
The taxpayer holding the debt also needs to determine whether the debt is a business or nonbusiness debt. Very broadly, business debt is any debt that arises in connection with a taxpayer’s trade or business, while a nonbusiness debt is everything else.2 This is a key factor. A business bad debt generally results in an ordinary deduction, whereas nonbusiness bad debts would result in short-term capital loss treatment, which may not be overly helpful to the taxpayer. Furthermore, only business debts are eligible for a partially worthless bad debt deduction, while nonbusiness bad debts are only deductible when wholly worthless.
To claim any bad debt deduction, a taxpayer must be able to demonstrate that the receivable or amount owed to them became worthless during the tax year, either in part or in whole, and that there is no reasonable expectation of recovery. The burden of proving worthlessness falls on the taxpayer and typically requires professional judgement by analyzing all the relevant facts and circumstances related to the debt.
The subjective nature of this determination could invite scrutiny from the IRS, therefore obtaining and documenting the evidence supporting a conclusion that a debt is worthless is always advised. This can be supported by financial statements of the debtor, collection efforts and correspondence, bankruptcy filings, settlement agreements, change in decline in collateral, among other corroborating evidence. Also, taxpayers must attach a statement to their respective income tax returns in the year in which they are claiming a bad debt deduction that highlights the particular facts substantiating any deduction claimed under Section 166.
Partially Worthless Bad Debt
A partially worthless bad debt is pretty much exactly what it sounds like. It is when a creditor determines that only a portion of a debt has become uncollectible during the tax year. This may occur in a bankruptcy situation where the debtor is only able to repay a portion or certain percentage of its outstanding liabilities, but not all. Or, possibly, the debt was in dispute, and the creditor and debtor negotiated a settlement that is typically for an amount less than the original liability that the creditor believes they were owed. The ability to claim a partial bad debt deduction allows the creditor to claim a tax deduction related to the debt while it is still legally outstanding and before it becomes wholly worthless, which could be years later.
To claim a partial bad debt deduction, the debt cannot be a “security,” otherwise the rules of Section 1653 take precedence, which is beyond the scope of this article. A security related to indebtedness, as defined under Section 165(g)(2)(C), includes a bond, debenture, note or certifi- cate, or other evidence of indebtedness issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form. In addition, the taxpayer must charge off the debt on its books4 in the tax year for which it is claiming the deduction.
While the write-off may be recorded to the general reserve account for U.S. GAAP purposes, it must be directly related to the specific debt to be deductible for tax purposes. This prevents the taxpayer from claiming a deduction for an asset when it still holds value on its balance sheet under other standards, such as U.S. generally accepted accounting principles. This requirement may seem like another hurdle, but it can be advantageous to the taxpayer and allows for flexibility in deciding when to take the deduction to maximize its benefit.
It is important to note that such flexibility in the timing of the deduction does not exist once the debt becomes wholly worthless, as the deduction must be taken in the year it becomes wholly worthless or it may be lost. In addition, consideration must be given to whether this is viewed as a change in method of accounting for income tax purposes, which requires the filing of Form 3115, Application for Change in Accounting Method.
Generally, the amount of the deduction is equal to the taxpayer’s adjusted basis in the debt – not its face value. For a taxpayer on the accrual method of accounting, this would generally be the face amount plus any original issue discount (OID) that has accrued while they held the debt and any accrued but unpaid interest on the debt. For a cash-basis taxpayer, the amount of the deduction would generally be the face amount plus any OID. If a debt held by a cash-basis taxpayer were a trade receivable, there would be no bad debt deduction since they did not previously report any income on the receivable and therefore have no cost basis in the debt.
While claiming a bad debt deduction typically would not involve an actual exchange of assets, caution should be given when a taxpayer receives a partial payment in the retirement of the debt instrument. This could invoke other implications, such as Section 1271 exchange treatment, which may lead to capital loss characterization if the debt instrument is a capital asset in the hands of the taxpayer.
Conclusion
Bad debts will always be a part of doing business or extending credit, but understanding the tax implications can help mitigate financial losses. When a bad debt becomes partially worthless, the ability to claim a deduction can provide relief for taxpayers. However, navigating the rules under Section 166 requires careful attention to detail, proper documentation, and an ability to clearly demonstrate worthlessness. Businesses and individuals alike should be proactive in taking steps to monitor their receivables, document collection efforts, and consult tax professionals when necessary. By doing so, they can ensure compliance with tax rules and maximize allowable deductions. Ultimately, a well-informed approach to bad debts can turn a challenging situation into an opportunity for better financial management and tax efficiency.
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1 Treas. Reg. Section 1.166-1(c).
2 Generally, bad debts of a corporation (other than an S corp) are always treated as business bad debts. See Section 166(d)(1).
3 Section 165 generally pertains to certain losses with specific limitations, including casualty losses, theft, and worthless securities.
4 Section 166(a)(2) and Treas. Reg. Sec- tion 1.166-3(a)(2). Generally, all taxpayers, except for certain financial institutions, must use this specific charge-off method. How- ever, certain service-based accrual method businesses may be able to use the nonaccrual experience method under Section 448(d)(5).
