Bad debts are funds owing to a business which are determined to be uncollectible. The determination of when a debt is uncollectible, and therefore "bad", may be based on a discharge in bankruptcy, the running of the statute of limitations to bring a lawsuit, disappearance of the debtor, a pattern of avoiding debts or the destruction of the collateral security.
Bad debts may be deductible against ordinary income on the federal income tax Form 1040 Schedule C and such a personal debt is deductible against short-term capital gains. Cash-basis taxpayers generally will not have reported income due them as an open account receivable. Since the basis of the receivable is zero, no deduction is allowed when the debt becomes uncollectible. However, income of a cash-basis taxpayer that is evidenced by a note is reportable when the note is received. Therefore, notes receivable of cash-basis taxpayers do have a basis and would be charged off upon becoming worthless.
Accrual-basis taxpayers generally report income as it is earned. Therefore, they may take a bad-debt deduction on accounts or notes that have become worthless during the year. However, the item must have been included in income either for the year of the deduction of the bad debt or in a previous year.
