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The Tax Reform Act of 1986 repealed the reserve method of accounting for most taxpayers.¹ As a result, all taxpayers, except for certain financial institutions, must use the specific charge-off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