An IRS ruling1 highlights that there is a right way and a wrong way to charge a bad debt off the books. The ruling is unusual in that after finding that the taxpayer did not charge off the debt correctly, it explained how the taxpayer could have done so correctly.
Business taxpayers are generally permitted partial bad debt deductions. However, the amount of the deduction is limited to the amount "charged off" for accounting purposes during the taxable year. The taxpayer in the ruling set up a general allowance account on its balance sheet as evidence that a mortgage loan was impaired. The offsetting entry was to reduce net income. The IRS took the position that a mere allowance or reserve for anticipated future losses does not meet the statutory requirement of a charge-off.
The authors of the ruling noted that the conclusion might have been different if the taxpayer used a reserve with the word "loss" in the title and had expensed the amount as a bad debt. Such an entry would have indicated a sustained loss as opposed to an anticipated future loss.
In many cases, taxpayers set up reserves and allowances for debt impairments without seeking the help of tax professionals, an unfortunate decision. The entry for impairment of a loan or debt is one of the few times in which the actual book entry has tax consequences. The fact that small differences in words in a ledger can result in the allowance or disallowance of a deduction brings home the importance of getting tax professionals involved when setting up the book entry.
1 Field Attorney Advice 20153501F
Questions? Contact your Berdon advisor.