8757 / What accounting methods are available for a taxpayer to use in accounting for bad debts?

The Tax Reform Act of 1986 repealed the reserve method of accounting for most taxpayers.¹ As a result, all taxpayers, except for certain financial institutions, must use the specific charge-off method in accounting for bad debts. Financial institutions may still be permitted to use the reserve method in accounting for bad debts.

Under the specific charge-off method, the taxpayer deducts amounts that were charged off on
its books during the tax year in question. To “charge-off” an item, a taxpayer can use any method that shows the intent to remove the debt as an asset.² The taxpayer must be the creditor both at the time that the worthlessness was determined and at the time the debt was charged-off³ (to allow otherwise would permit the taxpayer to claim a deduction for a loss that he did not own).

A debt that is “significantly modified” is deemed charged off.⁴ A modification means any alteration of the legal rights or obligations of a lender or borrower, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. A modification includes any total or partial deletion from, or addition to, such rights or obligations, but excludes an alteration that occurs by operation of the terms of a debt instrument (i.e., the annual resetting of an interest rate). As a general rule, a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.⁵ Treasury Regulation Section 1.1001-3(e)-(f) provides rules for determining when specific modifications are significant.⁶

The taxpayer must file a statement of facts substantiating the deduction along with the tax return containing the claim for the bad debt deduction.⁷

Financial institutions are also entitled to use the reserve method to account for losses resulting from bad debts. Instead of deducting specific bad debts from gross income, a financial institution can choose to deduct a reasonable amount as a reserve for bad debts. An account must be maintained for the bad debt reserves.⁸ The reasonableness of the amount claimed is a question of fact. Factors that are often considered in making the reasonableness determination include the type of business involved and the amount of the bad debt.⁹ What is reasonable in one business can vary from that which is reasonable for another business or in a different geographical area.

In using the reserve method, the taxpayer must file a statement of facts in support of the claim for the bad debt deduction. The statement must contain the following information:

(1)  the amount of charge sales or other business transactions for the year and the percentage of the reserve from these sales;

(2)  the total amount of the business’ notes and accounts receivable at both the beginning and at the end of the tax year;

(3)  the amount of debts that has become wholly or partially worthless and the amounts charged against the reserve account; and

(4)  how the additional amount to the reserve account was determined.¹⁰

Special rules apply to certain banks claiming bad debt deductions.¹¹

If a claim for a bad debt deduction is disallowed during one tax year, but subsequently the debt actually does become worthless, the taxpayer has seven years to file a claim for refund for the year that the debt actually became worthless.¹² This extension applies both to losses claimed under the specific charge-off method and under the reserve method.¹³ This extended period does not apply to partially worthless debt (see Q 8758).¹⁴