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Just because it’s a business loss doesn’t always make it tax deductible

Just because it’s a business loss doesn’t always make it tax deductible

What chiropractor hasn’t suffered from patients or insurance companies not paying?

Accounts receivable are not always collected in full, and some claims aren’t settled due to a variety of reasons. Sometimes patients simply evade payment, and the cost of pursuing them is more than the recoverable amount; sometimes they become bankrupt, sometimes the debt becomes time-barred, etc.

Bottom line: Sometimes no matter how hard the practice tries, it just can’t bring a particular patient’s account to zero. Even after friendly attempts at collection, a practice may not receive the total amount owed and begin to suspect it never will. At that point, certain choices exist: Write off the account as a bad debt, or forgive the debt entirely.

Either approach carries tradeoffs for small chiropractic practices.

Good bad debt vs. bad debt

Business and nonbusiness bad debts have markedly different treatments under the tax rules. A nonbusiness bad debt is deductible only when completely worthless, and then only as a short-term capital loss. Business bad debts, on the other hand, can be deducted even if only partially worth- less—and used to offset a practice’s ordinary income.

Unfortunately, merely labeling something as a business bad debt doesn’t necessarily make it tax deductible. A bad debt deduction can be claimed only if the amount owed was included in the practice’s gross income for the year the deduction is claimed.

This is almost never the case for cash method taxpayers (that means most of us who report income when we receive it). Accrual taxpayers, however, report income as it’s earned; if receivables have already been claimed as income, a bad debt deduction for uncollectible receivables is appropriate.

Forgiveness or write-offs?

Some chiropractic practices forgive the outstanding debts of those who have fallen on hard times. “Debt forgiveness” means that open accounts receivable will be written down to zero, with some sort of offsetting note explanation. Although there is no tax deduction associated with this adjustment, in some instances a Form 1099-C, Cancellation of Debt, must be filed with the IRS to record the cancellation of debt of more than $600.

A bad debt is defined as an account or note receivable that proves to be entirely or partially uncollectable despite collection efforts. For a practice to deduct a business bad debt as an expense on its tax return, the debt must have been created or acquired by the practice, or closely related to the practice, when it became partly or totally worthless.

Good bad debts

The IRS has denied some bad-debt deductions, even partial bad-debt deductions, because the rules weren’t followed. In one instance, a taxpayer was denied a partial bad-debt deduction because the amounts were not charged off strictly in accordance with the rules. An increased reserve account did not satisfy the statutory requirement that there be a charge-off.

According to the IRS, the purpose of requiring a charge-off is to perpetuate evidence of a taxpayer’s election to abandon part of the debt. Therefore, a practice must eliminate the debt as an asset on its books in order to comply with the charge-off requirement.

What’s more, before your practice can charge off and deduct a debt in part, you must be able to show that in the year partial-worthlessness was claimed, the amount of the worthlessness could be predicted with reasonable certainty. Bad debts are written off as soon as they are determined because the practice does not expect future economic benefits and it no longer remains an asset.

No way around it, the ultimate proof of worthlessness depends on the facts and circumstances as they existed at the time the debt was claimed to have become worthless.

A personal bad debt is ordinarily not deductible. However, in those rare cases where it is allowed as a deduction by the IRS, it would be treated as a short-term capital loss—limited to $3,000 per year.

Strictly business

Bad debts are written off as soon as it can be determined that the practice does not expect future economic benefits and it no longer remains an asset. A business bad debt is a loss from the worthlessness of a debt that was either:

  • Created or acquired in a trade or business, or
  • Closely related to the trade or business when it became partly or totally worthless.

A debt is closely related to a trade or business if the primary motive for incurring the debt is practice-related. Bad debts of an incorporated practice (other than an S corporation) are always business bad debts.

After a reasonable period of time, if the attempts made to collect the amount due are unsuccessful, the uncollect- ible part becomes a business bad debt.

In the beginning

Business bad debts are usually the result of credit sales to patients. Services that have been performed—but not yet paid for—are recorded in the practice’s books as either accounts or notes receivable. After a reasonable period of time, after unsuccessful attempts have been made to collect the amount due, the uncollectible portion becomes a legitimate and deductible business bad debt.

Under the tax rules, accounts or notes receivable at fair market value (FMV) when received are deductible only at that value, even though the FMV may be less than the face value.

When money is loaned to a customer, client, supplier, or employee for a business reason and the practice is unable to collect the amount after making a reasonable attempt, it becomes a business bad debt. On the other hand, a bad-debt deduction for a loan made to a corporation cannot be claimed if, based on the facts and circumstances, the loan is actually a contribution to capital.

The value of worthless debts

Generally, a debt becomes worthless when the surrounding facts and circumstances indicate there is no reasonable expectation of payment. To show that a debt is worthless, you must prove that reasonable steps were taken to collect the debt. It is not necessary to go to court if it can be shown that a judgment from the court would be uncollectible.

And, be careful to note if you do this, the deduction can be claimed only in the year the debt becomes worth- less. Naturally, it isn’t necessary to wait until a debt is due to determine whether it is worthless. Bankruptcy of the debtor is generally good evidence of the worthlessness of at least a part of an unsecured and non-preferred debt.

Note that bad debt deductions generally aren’t available to practices using the cash method of accounting. To deduct a bad debt, your practice must have previously included the amount in income.

Recovering bad debts

If you claim a deduction for a bad debt and later all or part is recovered (collected), all or part of the recovery amounts may have to be included as gross income in the year of recovery. The amount included is limited to the amount deducted.

Naturally, any amount deducted that did not reduce the earlier tax bill can be excluded. The recovery is usually reported as “Other Income” on the appropriate business form or schedule.

In the event that property is received in partial settlement of a debt, the debt is reduced by the property’s fair market value, which becomes the property’s basis or book value. The remaining debt can be deducted as a bad debt if and when it becomes worthless. Should the property later be sold for more than its basis, any gain on the sale is due to the appreciation of the property. It is not the recovery of a bad debt.

Besides costing your practice money, bad debts complicate accounting. When using accrual-basis accounting (as many practices do), income is realized at the time of billing, not when it is received.

Because of this lag as the unpaid fees become overdue accounts, many chiropractors go through various collection procedures with the overdue account eventually becoming a bad debt deductible on their tax return.

Naturally, you must be able to show that any “bad debt” is partially or totally worthless. To ensure you don’t miss out on a bad-debt deduction in the current tax year, periodically  review your records to pinpoint any potentially worthless receivables that might be carried on your books. It is also wise to ensure that all failed collection efforts have been documented should the IRS challenge the bad-debt deduction.

As this discussion makes clear, the bad-debt rules are tricky. Seeking professional assistance with the documentation requirements of these rules is always a smart move.

Mark E. Battersby is a tax and financial adviser, freelance writer, lecturer, and author located in Philadelphia. He can be reached at 610-789-2480.


Disclaimer: The author is not engaged in rendering tax, legal, or accounting advice. Consult your professional adviser about issues related to your practice.

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