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How to realize tax savings with bad debt
Be sure to document all failed collection efforts.
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What optometric professional hasn’t suffered with patients not paying? Accounts receivable are not always collected in full, and claims are rarely settled due to a variety of reasons. Sometimes patients simply evade payment, and the cost of pursuing them is more than the recoverable amount; sometimes they become bankrupt, sometimes the debt becomes time-barred.
The bottom line is that no matter how hard the practice tries, it just cannot bring a particular account to zero. Even after friendly attempts at collection, a practice may not receive the total amount owed and begin to suspect they never will. At that point, certain choices exist: Write off the account as a bad debt or forgive the debt entirely. Each approach carries tradeoffs for small optometric practices.
Good bad debt vs. bad bad debt
Business and nonbusiness bad debts have markedly different treatments under our tax rules. A nonbusiness bad debt is deductible only when completely worthless, and then only as a short-term capital loss. Business bad debts, on the other hand, can be deducted even if only partially worthless and used to offset ordinary income.
Unfortunately, merely labeling something as a business bad debt does not necessarily make it tax deductible. A bad debt deduction can be claimed only if the amount owed was included in gross income for the year the deduction is claimed. This is almost never the case for cash method taxpayers (that means most of us who report income when we receive it). Accrual method taxpayers, however, report income as it is earned; if receivables have already been claimed as income, a bad debt deduction for uncollectible receivables is appropriate.
Forgiveness or write-offs
Some optometrists and optometric practices forgive the outstanding debts of those who may have fallen on hard times. Debt forgiveness simply means the open account receivables will be written down to zero, with some sort of offsetting note explanation.
Although there is no tax deduction associated with this adjustment, a Form 1099-C, Cancellation of Debt, must be filed with the IRS to record the cancellation of debt of more than $600.
Good bad debts
A bad debt is defined as an account or note receivable that proves to be entirely or partially uncollectable despite collection efforts. For an optometric practice to deduct business bad debts as an expense on its tax return, the debt must have been created or acquired by the practice or closely related to the practice when it became partly or totally worthless.
Unfortunately, the IRS often denies bad debt deductions, even partial bad debt deductions, simply because the rules were not followed. In one instance, a practice was denied a partial bad debt deduction because the amounts were not charged off strictly in accordance with the rules. An increased reserve account did not satisfy the statutory requirement that there be a charge-off.
According to the IRS, the purpose of requiring a charge-off is to perpetuate evidence of a taxpayer’s election to abandon part of the debt. Therefore, an optometrist or his or her practice must eliminate the debt as an asset on its books in order to comply with the charge-off requirement.
What’s more, before any optometric practice can charge off and deduct a debt in part, it must be able to show that in the year partial worthlessness was claimed, the amount of the worthlessness could be predicted with reasonable certainty. Bad debts are written off as soon as they are determined because the optometric practice does not expect future economic benefits and it no longer remains an asset. No way around it, the ultimate proof of worthlessness depends upon the facts and circumstances as they existed at the time the debt was claimed to have become worthless.
A personal bad debt is ordinarily not deductible. However, in those rare cases where it is allowed as a deduction by the IRS, it would be treated as a short-term capital loss, limited to $3,000 per year.
Business bad debt
As mentioned, bad debts are written off as soon as it can be determined that the optometric practice does not expect future economic benefits and it no longer remains an asset. A business bad debt is a loss from the worthlessness of a debt that was either:
- created or acquired in a trade or business or
- closely related to the trade or business when it became partly or totally worthless.
A debt is closely related to a trade or business if the primary motive for incurring the debt is practice-related. Bad debts of an incorporated optometric practice (other than an S corporation) are always business bad debts.
Business bad debts are usually the result of extending credit to patients, third-party payors or insurers. Services that have been performed, even goods that have been sold, but not yet paid for, are recorded in the practice’s books as either accounts or notes receivable. After a reasonable period of time, if attempts have been made to collect the amount due but were unsuccessful, the uncollectible part becomes a business bad debt.
Under our tax rules, accounts or notes receivable valued at fair market value (FMV) when received are deductible only at that value, even though the FMV may be less than the face value.
When money is loaned to a patient, customer, client, supplier or employee for a business reason, and the practice is unable to collect the amount after a reasonable attempt, it becomes a business bad debt. On the other hand, a bad debt deduction for a loan made to a corporation cannot be claimed if, based on the facts and circumstances, the loan is actually a contribution to capital.
The value of worthless debts
Generally, a debt becomes worthless when the surrounding facts and circumstances indicate there is no reasonable expectation of payment. To show that a debt is worthless, an optometric professional must establish that reasonable steps have been taken to collect it. It is not necessary to go to court if it can be shown that a judgment from the court would be uncollectible.
In addition, the deduction can be claimed only in the year the debt becomes worthless. Naturally, it is not necessary to wait until a debt is due to determine whether it is worthless. Bankruptcy of the debtor is generally good evidence of the worthlessness of at least a part of an unsecured and nonpreferred debt.
Once again, it should be noted that bad debt deductions generally are not available to optometrists or practices that use the cash method of accounting. To deduct a bad debt, the optometrist or his or her practice must have previously included the amount in income.
Recovering bad debts
If a deduction for a bad debt is claimed and later all or part is recovered (collected), all or part of the recovery amounts may have to be included in the optometric practice’s gross income in the year of recovery. The amount included is limited to the amount actually deducted. Naturally, any amount deducted that did not reduce the earlier tax bill can usually be excluded. The recovery is usually reported as “other income” on the appropriate business form or schedule.
In the event that property is received in partial settlement of a debt, the debt is reduced by the property’s FMV, which becomes the property’s basis or book value. The remaining debt can be deducted as a bad debt if and when it becomes worthless. Should the property later be sold for more than its basis, any gain on the sale is due to the appreciation of the property. It is not a recovery of a bad debt.
Nonaccrual-experience method
If the accrual method of accounting is used, income expected to be uncollectible does not have to be accrued under the “nonaccrual-experience method.” Because the expected uncollectible amounts are not included in income, these amounts are not later deducted from income. Generally, the practice must have $5 million in gross receipts for all prior years to use this simplified strategy.
In addition to costing the optometric practice money, bad debts complicate accounting. When using accrual-basis accounting (as many practices do), income is realized at the time of billing, not when it is received. Because of this time lag as the unpaid fees become overdue accounts, many optometrists go through various collection procedures, with the overdue account eventually becoming a bad debt deductible on the optometric practice’s tax return.
Naturally, the optometrist or practice must be able to show that any “bad debt” is partially or totally worthless. To ensure the optometric practice does not miss out on a bad debt deduction in the current tax year, records should be reviewed carefully to pinpoint any potentially worthless receivables still carried on the books. It is also a wise move to make sure all failed collection efforts are carefully documented in case the IRS challenges the bad debt deduction.
Obviously, the bad debt rules are tricky and require substantiation, special procedures and records. Every optometric professional with questions should be sure to check with their tax professional.
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- Mark E. Battersby has been reporting on news and developments in the tax and financial arenas for more than 25 years. He can be reached at MEBatt12@Earthlink.net.
Disclosure: Battersby has no relevant financial disclosures.