Business Tax Preparation · Business expenses, deductions and credits

Business bad debts

Two questions decide a bad debt deduction and the second is worth far more than the first. Is there a debt that has become worthless, and is it a business debt? The answer to the second turns an ordinary deduction into a short-term capital loss, or the reverse.

The rule

The deduction. a deduction is allowed for any debt which becomes worthless within the taxable year^TY2026Verified 2026-08-21IRC § 166(a)(1), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(a)(1)). For less than the whole, where the Secretary is satisfied that a debt is recoverable only in part, a deduction may be allowed in an amount not exceeding the part charged off within the taxable year — so a partial deduction requires an actual charge-off and a wholly worthless one does not^TY2026Verified 2026-08-21IRC § 166(a)(2), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(a)(2)).

How much. the adjusted basis provided in IRC § 1011 for determining loss on a sale — so a cash-method lender's unpaid interest, never included in income, has no basis and produces no deduction^TY2026Verified 2026-08-19IRC § 166(b) — https://www.law.cornell.edu/uscode/text/26/166 (IRC § 166(b)), and a worthless debt arising from unpaid wages, salaries, fees, rents and similar items of taxable income is not deductible unless the income it represents has been included on a return for the year of the deduction or an earlier year^TY2026Verified 2026-08-21Reg. § 1.166-1(e), opened at law.cornell.edu/cfr/text/26/1.166-1 (Reg. § 1.166-1(e)).

Business or not. for a taxpayer other than a corporation, IRC § 166(a) does not apply to a non-business debt; a non-business debt that becomes worthless is treated as a loss from the sale or exchange of a capital asset held for not more than 1 year — a short-term capital loss, and only when wholly worthless^TY2026Verified 2026-08-21IRC § 166(d)(1), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(d)(1)). A business debt is a debt created or acquired in connection with the taxpayer's trade or business, or a debt the loss from the worthlessness of which is incurred in that trade or business^TY2026Verified 2026-08-21IRC § 166(d)(2), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(d)(2)), and the test is applied so that the character of the debt turns on the relation the loss bears to the trade or business at the time the debt becomes worthless; if that relation is a proximate one, the debt is a business debt, and the use the debtor made of the funds is of no consequence^TY2026Verified 2026-08-21Reg. § 1.166-5(b), opened at law.cornell.edu/cfr/text/26/1.166-5 (Reg. § 1.166-5(b)).

Proving worthlessness. all pertinent evidence is considered, including the value of any collateral and the financial condition of the debtor; legal action is not required where the circumstances show that enforcing payment would in all probability not result in satisfaction of a judgment^TY2026Verified 2026-08-21Reg. § 1.166-2(a) and (b), opened at law.cornell.edu/cfr/text/26/1.166-2 (Reg. § 1.166-2(a), (b)), and bankruptcy is generally an indication of the worthlessness of at least a part of an unsecured and unpreferred debt^TY2026Verified 2026-08-21Reg. § 1.166-2(c)(1), opened at law.cornell.edu/cfr/text/26/1.166-2 (Reg. § 1.166-2(c)(1)).

If it comes back. an amount recovered on a debt allowed as a deduction in a prior year is included in gross income for the year of recovery, except so far as the tax benefit rule of IRC § 111 excludes it^TY2026Verified 2026-08-21Reg. § 1.166-1(f), opened at law.cornell.edu/cfr/text/26/1.166-1 (Reg. § 1.166-1(f)).

Current figures

How it works in practice

Three differences follow from the business or non-business classification, not one. A business bad debt is an ordinary deduction; a non-business bad debt is for a taxpayer other than a corporation, IRC § 166(a) does not apply to a non-business debt; a non-business debt that becomes worthless is treated as a loss from the sale or exchange of a capital asset held for not more than 1 year — a short-term capital loss, and only when wholly worthless^TY2026Verified 2026-08-21IRC § 166(d)(1), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(d)(1)), and therefore runs into the capital loss limitation. A business bad debt may be deducted in part under IRC § 166(a)(2); a non-business one may not, because IRC § 166(d)(1)(A) switches off IRC § 166(a) entirely and IRC § 166(d)(1)(B) engages only when the debt “becomes worthless.” And a business bad debt takes the holding period of nothing at all, while a non-business one is deemed short-term however long it was outstanding.

A corporation cannot have a non-business bad debt. IRC § 166(d)(1) opens “In the case of a taxpayer other than a corporation.” Every debt a corporation holds is therefore within IRC § 166(a), and the classification question does not arise.

The classification test is about the loss, not the loan. the character of the debt turns on the relation the loss bears to the trade or business at the time the debt becomes worthless; if that relation is a proximate one, the debt is a business debt, and the use the debtor made of the funds is of no consequence^TY2026Verified 2026-08-21Reg. § 1.166-5(b), opened at law.cornell.edu/cfr/text/26/1.166-5 (Reg. § 1.166-5(b)). Two points in that sentence do the work. The relation is tested “at the time the debt becomes worthless,” so a loan made in the course of a business the taxpayer has since left may have lost its character. And “the use to which the borrowed funds are put by the debtor is of no consequence” — lending to a business does not make the debt a business debt of the lender.

Basis is the ceiling, and a cash method business often has none. the adjusted basis provided in IRC § 1011 for determining loss on a sale — so a cash-method lender's unpaid interest, never included in income, has no basis and produces no deduction^TY2026Verified 2026-08-19IRC § 166(b) — https://www.law.cornell.edu/uscode/text/26/166 (IRC § 166(b)) and a worthless debt arising from unpaid wages, salaries, fees, rents and similar items of taxable income is not deductible unless the income it represents has been included on a return for the year of the deduction or an earlier year^TY2026Verified 2026-08-21Reg. § 1.166-1(e), opened at law.cornell.edu/cfr/text/26/1.166-1 (Reg. § 1.166-1(e)). A cash method consultant whose client never pays has no deduction: she never included the fee in income, so she has no basis in the receivable and nothing to write off. An accrual method consultant on identical facts included the fee, has basis equal to it, and deducts it. This is the same structural point that governs discharge of indebtedness under IRC § 108(e)(2), running in the opposite direction.

Partial worthlessness needs a charge-off; total worthlessness does not. where the Secretary is satisfied that a debt is recoverable only in part, a deduction may be allowed in an amount not exceeding the part charged off within the taxable year — so a partial deduction requires an actual charge-off and a wholly worthless one does not^TY2026Verified 2026-08-21IRC § 166(a)(2), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(a)(2)) — the deduction may not exceed “the part charged off within the taxable year,” so the books must show the write-down in the year claimed. IRC § 166(a)(1) imposes no such requirement, though in practice a taxpayer claiming a wholly worthless debt will have written it off anyway.

Worthlessness is a facts question with a low procedural bar. all pertinent evidence is considered, including the value of any collateral and the financial condition of the debtor; legal action is not required where the circumstances show that enforcing payment would in all probability not result in satisfaction of a judgment^TY2026Verified 2026-08-21Reg. § 1.166-2(a) and (b), opened at law.cornell.edu/cfr/text/26/1.166-2 (Reg. § 1.166-2(a), (b)). Suing is not required where suing would be futile, and bankruptcy is generally an indication of the worthlessness of at least a part of an unsecured and unpreferred debt^TY2026Verified 2026-08-21Reg. § 1.166-2(c)(1), opened at law.cornell.edu/cfr/text/26/1.166-2 (Reg. § 1.166-2(c)(1)). What the regulation does require is that the year be right: a debt is deductible in the year it becomes worthless, not in a later year when the taxpayer gets round to it, and an early claim is as wrong as a late one.

And if the money arrives after all. an amount recovered on a debt allowed as a deduction in a prior year is included in gross income for the year of recovery, except so far as the tax benefit rule of IRC § 111 excludes it^TY2026Verified 2026-08-21Reg. § 1.166-1(f), opened at law.cornell.edu/cfr/text/26/1.166-1 (Reg. § 1.166-1(f)). The recovery is income only to the extent the earlier deduction produced a tax benefit, which is the rule in IRC § 111.

How this has changed

The regulation still offers a method the statute abolished in 1986. the reserve method was repealed for most taxpayers by Pub. L. 99-514 § 805(a) in 1986, which struck IRC § 166(c) — but Reg. § 1.166-1(a)(2) and (b) still describe it as one of two methods a taxpayer may select^TY2026Verified 2026-08-21Repeal note at IRC § 166(c) and Reg. § 1.166-1(a), (b), both opened at law.cornell.edu/uscode/text/26/166 and /cfr/text/26/1.166-1. Reg. § 1.166-1(a) says bad debts “shall … be taken into account either as (1) A deduction in respect of debts which become worthless in whole or in part; or as (2) A deduction for a reasonable addition to a reserve for bad debts,” and Reg. § 1.166-1(b) then sets out how a taxpayer selects between the two methods and how the district director approves the selection. The authority for the second method was IRC § 166(c), and the bracketed note in the current statutory text records that Pub. L. 99-514 § 805(a) repealed it on 22 October 1986.

This is a familiar shape by now: the regulation was never conformed, so a reader working from the regulation alone will find a choice that no longer exists. The only reserve methods that survive are the special ones for financial institutions in IRC § 585 and IRC § 593, which are outside this topic. A taxpayer other than one of those uses the specific charge-off method and has no election to make.

Nothing in Pub. L. 119-21 amended IRC § 166, so the 2026 rules are the 2025 rules. The one adjacent change that reaches this topic in practice is the information reporting threshold. A business will receive fewer Forms 1099-NEC and 1099-K for 2026 than for 2025, which means fewer of its own receivables will have been reported to the customer — but this changes nothing about the deduction, because IRC § 166(b) and Reg. § 1.166-1(e) turn on whether the creditor included the income, not on whether anyone filed a form.

Exam focus

Classify first. Business or non-business decides the character, decides whether a partial deduction is available, and decides the holding period, and almost every question in the topic turns on it.

Apply the proximate relation test of Reg. § 1.166-5(b) to the lender’s business, at the time the debt becomes worthless, and ignore what the borrower did with the money.

Watch for a cash method creditor. If the facts mention the method of accounting at all, the answer is usually that there is no deduction, because there is no basis.

Finally, remember that partial worthlessness requires a charge-off in the year claimed and total worthlessness does not, and that a later recovery is income only so far as the earlier deduction gave a tax benefit.

Check yourself

1. A cash method architect is never paid a $30,000 fee she billed last year. What is her bad debt deduction?

Answer: None. a worthless debt arising from unpaid wages, salaries, fees, rents and similar items of taxable income is not deductible unless the income it represents has been included on a return for the year of the deduction or an earlier year^TY2026Verified 2026-08-21Reg. § 1.166-1(e), opened at law.cornell.edu/cfr/text/26/1.166-1 (Reg. § 1.166-1(e)) and the adjusted basis provided in IRC § 1011 for determining loss on a sale — so a cash-method lender's unpaid interest, never included in income, has no basis and produces no deduction^TY2026Verified 2026-08-19IRC § 166(b) — https://www.law.cornell.edu/uscode/text/26/166 (IRC § 166(b)) — she never included the fee in income, so she has no adjusted basis in the receivable and nothing to deduct.

2. An individual lends $25,000 to an unrelated company in which he has no interest and is not repaid after six years. How is the loss treated?

Answer: As a short-term capital loss. for a taxpayer other than a corporation, IRC § 166(a) does not apply to a non-business debt; a non-business debt that becomes worthless is treated as a loss from the sale or exchange of a capital asset held for not more than 1 year — a short-term capital loss, and only when wholly worthless^TY2026Verified 2026-08-21IRC § 166(d)(1), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(d)(1)) — the loss bears no proximate relation to any trade or business of his, so it is a non-business debt, deemed a loss from the sale of a capital asset held for not more than one year regardless of the six years it was outstanding.

3. A business is owed $50,000, charges off $30,000 as uncollectible in the current year, and believes the rest may still be paid. May it deduct $30,000?

Answer: Yes, if the debt is recoverable only in part. where the Secretary is satisfied that a debt is recoverable only in part, a deduction may be allowed in an amount not exceeding the part charged off within the taxable year — so a partial deduction requires an actual charge-off and a wholly worthless one does not^TY2026Verified 2026-08-21IRC § 166(a)(2), opened at law.cornell.edu/uscode/text/26/166 (IRC § 166(a)(2)) — the deduction may not exceed the part charged off within the taxable year, and $30,000 has been. A non-business debtor could not do this at all.

4. A sole proprietor lends money to a key supplier to keep it in business, and the supplier fails. Is this a business bad debt?

Answer: Yes, if the loss bears a proximate relation to the lender’s own trade or business at the time the debt becomes worthless. the character of the debt turns on the relation the loss bears to the trade or business at the time the debt becomes worthless; if that relation is a proximate one, the debt is a business debt, and the use the debtor made of the funds is of no consequence^TY2026Verified 2026-08-21Reg. § 1.166-5(b), opened at law.cornell.edu/cfr/text/26/1.166-5 (Reg. § 1.166-5(b)) — protecting a supply line for a business the taxpayer is still carrying on supplies that relation, and the deduction is ordinary.

5. May a taxpayer today elect the reserve method for bad debts described in Reg. § 1.166-1(a)(2)?

Answer: No. the reserve method was repealed for most taxpayers by Pub. L. 99-514 § 805(a) in 1986, which struck IRC § 166(c) — but Reg. § 1.166-1(a)(2) and (b) still describe it as one of two methods a taxpayer may select^TY2026Verified 2026-08-21Repeal note at IRC § 166(c) and Reg. § 1.166-1(a), (b), both opened at law.cornell.edu/uscode/text/26/166 and /cfr/text/26/1.166-1 — IRC § 166(c), which authorised it, was repealed by Pub. L. 99-514 § 805(a) in 1986. The regulation was never conformed and still describes the election, but the only surviving reserve methods are those for financial institutions in IRC § 585 and IRC § 593.