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Stake your claim to business bad-debt deductions

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Suppose a regular customer is experiencing economic difficulties. You've let that customer slide on several invoices, but now you're concerned you may never be paid. Should you aggressively pursue collection efforts or continue to gently remind the customer about the unpaid bills?

Best bet:
Pull out all the stops as the year comes to a close. Why? You can deduct a worthless receivable in the year that it becomes worthless, assuming your business uses the accrual method and has taken the receivable into income for tax purposes.

But to prove that a debt is worthless in 2005, you must show that you legitimately tried to collect it this year. Otherwise, you earn no deduction for 2005.

Keep detailed records of all your efforts, including copies of letters, phone calls, e-mails and collection-agency documentation. Set up file folders for your debt-collection activities. Hold onto these records for at least three years in case the IRS challenges your bad-debt deductions.

The accounting method for business bad debts is called the "specific charge-off method" because it requires you to identify specific debts and charge them off the books (i.e., remove debts as assets).

With the specific charge-off method, you can deduct business bad debts that are either partially worthless or totally worthless. (Nonbusiness bad debts can be deducted only when they become totally worthless.)

Partially worthless debts:
This gives you more flexibility than a totally worthless debt. You can charge off the part of the debt that's uncollectible and claim the deduction in the same year or the following year. For instance, you might postpone the write-off if you expect next year to be a high-income year for your business. Alternatively, you can wait until the debt becomes totally worthless.

Totally worthless debts: These debts must be deducted in the year they become worthless. The deduction can't include any amount previously deducted as a partially worthless debt. If the IRS subsequently rules a debt is only partially worthless, you can't claim any deduction until the year of the charge-off.

What happens if you deduct a bad debt and then recover some or all of it a later year? In such cases, you must report the recovery as taxable income, but only up to the amount that reduced your tax liability for the year of the write-off.

Example: Say you're self-employed and incurred a $10,000 worthless receivable loss in 2005 from your accrual-method business. After claiming itemized deductions and personal exemptions, the debt reduces your taxable income by $6,000. If the $10,000 debt is repaid in full in 2006, you report $6,000 in additional taxable income on your 2006 return.

Tip: It is particularly important for self-employed individuals to establish that bad debts are related to their business and aren't personal debts instead.

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