8755 / When can a taxpayer deduct losses sustained as a result of a bad debt? What is the difference between a business bad debt and a nonbusiness bad debt?

A bad debt is a specific obligation that can be deemed with reasonable certainty to have become totally or partially worthless. If this is the case, the creditor-taxpayer may be entitled to a deduction corresponding to the amount of the worthless debt.¹

There are two kinds of bad debt deductions: (1) business bad debts and (2) nonbusiness bad debts. A business bad debt, as the name suggests, is a debt that is incurred in the conduct of the taxpayer’s trade or business. A nonbusiness bad debt is defined, by exclusion, in IRC Section 166(d)(2) as a bad debt other than a debt (a) created in the conduct of the taxpayer’s business² or (b) the loss from the worthlessness of which was incurred in the conduct of the taxpayer’s trade or business.³ The second exclusionary rule allows a taxpayer who was not the original creditor to claim a worthless debt that he acquired in the conduct of his business.

The classification as either a business or nonbusiness bad debt is important because only a business bad debt can be treated as a deduction from ordinary income, while nonbusiness bad debts receive a capital loss treatment.⁴ Further, a taxpayer can claim a deduction for wholly or partially worthless business bad debts, while nonbusiness bad debts must be completely worthless for the deduction to be allowed (see Q 8758).⁵

Whether a debt is incurred in relation to a taxpayer’s trade or business, so as to be classified as a business bad debt, is a question of fact.⁶ In making the determination, it is important to note that a taxpayer is not restricted to one type of business and that there is no requirement that the loss be incurred in conducting the business in which the taxpayer spends the majority of taxpayer’s time.⁷

A deduction for a loss sustained as the result of a bad debt will only be permitted in cases where both a valid debt and a true debtor-creditor relationship exist (see Q 8756). Whether a valid debt or a true debtor-creditor relationship exists is also a question of fact.⁸

A bad debt deduction will not be allowed in a situation where the debt is secured by collateral and the creditor has foreclosed on the collateral due to nonpayment.⁹

Bad debts of corporations, except for S corporations, are always classified as business bad debts.¹⁰ An S corporation is required to separately state its nonbusiness bad debt, which is taxed under the rules applicable to short-term capital losses (see Q 8648).¹¹

A discharge of one’s obligation as a guarantor is considered a nonbusiness bad debt. The loss sustained by a guarantor unable to recover from the debtor is by its very nature a loss from a bad debt to which the guarantor becomes subrogated upon discharging his liability as guarantor.¹²

If the debt fails to qualify as a business bad debt, it can, in many cases, be treated as a nonbusiness bad debt.¹³ If the taxpayer fails to establish that a debt qualifies as a business bad debt under IRC Section 166, he must be satisfied with treatment as a nonbusiness bad debt under that same section and may not look to IRC Section 165 (see Q 8760) for an alternative means of treating loss on the debt as an ordinary loss deduction.¹⁴