8756 / When is a taxpayer entitled to claim a bad debt deduction?

A taxpayer may claim a bad debt deduction (whether it is a business bad debt or a nonbusiness bad debt, see Q 8755) for debt owed when the debt is a bona fide debt that has become worthless.1

A “bona fide debt” is one that arises from a debtor-creditor relationship involving a valid and enforceable agreement to pay a specific sum of money.² An agreement is considered to be a valid and enforceable agreement if it includes an unconditional promise by a debtor to pay the creditor.³

A taxpayer’s voluntary undertaking to pay another debtor’s obligations does not give rise to a valid and enforceable agreement for this purpose. Despite this, if the taxpayer volunteers to pay another person’s obligation for a business purpose, and that debt subsequently becomes worthless, the taxpayer may be entitled to deduct the amount of the loss as a business expense under IRC Section 162.⁴