 session, in which we will discuss bad debt for tax purposes. What is the big idea of bad debt? Well, bad debt gets created, occurred when we sell on credit. What does that mean? It means when you have a business, you might make a sale by debiting a account receivable for $10,000, credit sales, $10,000, you expect to receive this money down the road in 30 days. In 30 days, in 60 days, in 90 days, you try to collect the money and the customer, whoever that customer is, ABC customer, don't pay their bill. Well, if that's the case, you're going to have to turn the account receivable into a bad debt expense. Simply put, your account receivable turned into a bad debt expense. What happened is you have to record an expense and credit the account receivable. I mean, this is the simple illustration of it, just to understand the big idea of bad debt. The same concept could apply rather than making a sale if you made a loan. If you made a loan, you would have debit, rather than a account receivable, you will debit notes receivable if you lend this money to ABC and you credit cash. You expect to get your money back plus interest. If you don't, you're going to debit that expense and credit the notes receivable for ABC company. Now, let's look into the details a little bit further. If a taxpayer sells on credit and subsequently the account receivable becomes incollectable, as I showed you, they are permitted to claim a bad debt deduction. It means the account receivable, the asset, turns into a bad debt. Now, bear in mind, this is only applicable if the income associated with the account receivable was previously reported as income. So what are we assuming here? We are assuming that you debit the account receivable and credited sales mean credited the income. So the income was included. In contrast, most taxpayer, if a taxpayer operates on a cash basis where income is reported only after cash is collected, you cannot have a deduction for bad debt because you never had a sale in the first place. So if you never had a sale, you cannot have bad debt. So the bad debt occur when the business is selling on account using account receivable, which is the some sort of an accrual method. So let's go ahead and dive a little bit more into this concept. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. Let's look at this illustration. Monica, a self-employed professional runs a business called Comprehensive Business Solution and Tax Consulting. Last year, what she did, she performed some work for Jake, and Monica prepared Jake's as corporation tax return and his personal income tax return, and she invoiced him $10,000 for the services. Guess what? Jake never paid, never settled his bill, and his business ceased to exist, and his current location is undetermined. Now, if Monica is an accrual basis, accrual basis means in the prior year, she recorded the $10,000 as revenue. Well, if Monica operates on accrual, she would record the $10,000 of income at the time of the service was provided. Now, once she realizes that Jake's account is incollectible, it means that Jake is gone, she can't find him, she can't collect, she will write off the account as bed debt, then she will have a bed debt expense of $10,000. Now, bear in mind, if Monica, now this is a different scenario, is a cash basis tax payer, she would not record the $10,000 from Jake because she never received it. Therefore, when she find out that Jake account will not be paid, she cannot claim a $10,000 bed debt expense since she was never included, she never included this $10,000 in income. So, the point I am trying to make is this, you can only have a write off, you can only record bed debt if you already have an account receivable, that's the first thing you need to know. No account receivable, no bed debt because you never recorded the income in the first place. Now, for tax purposes, because look, this is a tax course, you're going to learn this for tax purposes, you already learned this most likely for financial accounting. For financial accounting, if you are using a cruel, you would use something called the allowance method. For tax purposes, you cannot use the allowance method, for tax purposes, you have to use something called the specific charge or the specific write off or the direct write off method. So, this is what we're going to be discussing next. Accounting for bed debt for tax purposes uses the specific write off or direct write off method, the specific charge in contrast to the allowance method or the reserve method for financial accounting. Again, if you're interested in this, go to my financial accounting and intermediate accounting to learn about the allowance method. The specific charge off method is different. So, when do we deduct a receivable? We can deduct a receivable when the business debt, if we have a business debt becomes partially or fully worthless within one year. So, if we cannot collect the money, if we cannot collect our money or we can collect only partial of it and that debt is a business debt, what does that mean? It means we sold some product to this client, then whether it's partially in collectible or fully in collectible, we can deduct we can deduct it as long as we determine that that amount is in collectible and as long as we already computed a counter receivable. For non-business debt, non-business means personal debt, personal debt in contrast to business debt and deduction can only be claimed if the debt is entirely worthless. So, we have to wait until the debt is becomes entirely worthless. Now, the taxpayer, when they have a business, they must provide evidence of the debt worthliness, whether a business or non-business without needing to undergo legal proceeding provided that they can prove unlikely collection, unlikely collection evidence. Now, how do you provide? How can you tell? How can you determine that the account becomes in collectible? How do you determine this? Because remember, if you booked a deduction and you said this is a bad debt expense, you might have to be standing in front of the IRS explaining yourself why did you take that deduction? Well, what can you show the IRS? Well, you can show, for example, the customer went bankrupt. If the customer went bankrupt, most likely you will not be paying. You have to show your collection effort. You have to show that you are sending them letters. You have to show that you are calling them. You have to show they may be your lawyer is sending them letters, asking them to pay. You might have to show that you are giving them a personal visit. You might be saying, really? And I would say, yeah, right, personal visit. You might be thinking this does not happen. Yes, it happens. Actually, my first job out of college, I work for a company called City Financial. Don't tell anyone. It's a discount loan. And part of my job, well, was to issue loans to receive payments, but also to collect to collect payment. And when customers don't pay, we try to collect from them. So the office City Financial, they pride themselves on the fact that they issued a loan from the office, they receive the money in the office, they give you the money from the office, everything is from the office. So part of the job was to collect money. And I still remember when I was young and stupid. My boss sent me to a bar to a local bar, because we know one of our clients that we lost a track of owes us money, owes us money, send me to a local bar because we know he hang out there that, you know, maybe we should remind him just kind of, you know, you owe us the money. What are you planning to pay us? So again, as I'm young and stupid, I went to that bar, just, you know, innocently going and asking for this guy who I don't know who he is, I just know his name is walking to the bar us, you know, I'm looking for this guy said, yeah, this guy sitting over there. The guy was a biker, is a big guy with a biker and he was scared in the gun. And I was like, at that point, I was shaking. I was like, okay, this is your bill, you owe us this money, you know, when are you planning to pay? So the point is, also, we have to show that we try to collect the money before a business can write off debt. That's that's the point I'm trying to make. So you have to show evidence that you try to collect the money. Let's assume in 20 x one, Robert lent $2,000 to Paul, with it, with the agreement that Paul would pay back the loan in two years. In 20 x three, Paul vanished. Okay, never pay back the loan. Upon thorough investigation, Robert concluded that Paul is that suing Paul or finding Paul is not a good idea. Just it's waste of time. Okay, Robert then can deduct the $2,000 and 20 x three, because that's it. I can't find Paul. I made an effort. I can't soon because I can't find them. Therefore, I have a I have a bad debt. Now let's assume in 20 x two the following year, Paul filed for personal bankruptcy. And the loan that assumed the loan is a business debt. Well, at this point, to say, Okay, if the loan is a business debt, now we might have a deduction. At this time, Robert learned that the unsecured creditors unsecured means you gave them money and you did not take anything escalatural, including himself. He's a part of the unsecured creditor were projected were likely to receive 20 cent for every dollar. Now I gave this individual, Robert is thinking I gave them 2000, I can only collect 20% of this 20% of this is how much $400. So I'm going to only collect $400. What does that mean? It means in I can only get 1000, I'm sorry, 400. Yes, I can only I'm going to have to write off 1600. When the settlement is reached, Robert received 300. So on 20 x two, so on 20 x two, what did I do? I, I means Robert wrote off 1600, hoping in 20 x three, when everything settled, he would receive the $400. Well, Robert received only $300. Robert should deduct 1600, the original amount minus the expected amount in 20 x two. And in 20 x three, Robert can deduct an additional $100. Why? Because of the 400 that I thought I'm going to be receiving, I only received Robert received three of the of the 400. Now bear in mind, if a debt deemed in collectible and written off in later years, it was recovered. It means the client came back and paid you. Let's assume Paul came back out of nowhere and pay Robert, it would result in income of the initial deduction provided a tax benefit. So in later years, if Paul came back and pay Robert, since Robert already took the deduction, then Robert will have to include that in his income because of the tax benefit rule. Let's discuss another important concept to differentiate between business, because we kept saying business versus non-business, but we never explain why business versus non-business loan is important. So the classification is important. Okay. And this classification of the debt, whether it's a business or non-business, depend on that lender's role, not how the borrower uses the money, it's what's the lender's role? What role is the lender playing? For example, a personal loan, okay, should not be linked to the lender's trade or business. So to be a personal loan, you're making a loan that it has nothing to do with your personal business. Usually, what are we talking about here? We're talking about loans between families. So a non-business bad debt is when someone, a person, an individual, lend money to another person, usually a family or a friend. And that's the best way to lose a friend. If you don't like a friend and you want to lose them, lend them money, especially family member. That's the fastest way you can lose your friends. But if you want to lose a friend, lend them money and you will never see them again. So a non-business debt is different than a business debt. A business debt and is when that loan or when that debit or credit or relationship is established from the business or the trade. Now, the difference between business and non-business is crucial. Why? Because from a tax perspective, you have to understand this. A business bad debt is considered an ordinary deduction, ordinary deduction for the year it's incurred. While a personal bad debt, if you lost this money, it's a short-term capital loss. And what do we know about short-term capital loss? The maximum you can deduct is 3,000 for individual per year. However, if this is a bad debt and you lend someone $10,000, this amount is incollectible. You need all the business incollectability. Then you have a deduction of 10,000. However, if you lend someone a personal loan, 10,000, and you lost this money, you can only deduct 3,000 out of it. Now, let's take a look at a summary of business versus non-business debt. When can you take the deduction? For a business bad debt, deduction can be claimed when the business becomes partially or fully incollectible. For a personal debt, the loan before you can deduct that 3,000, the loan has to be completely, completely incollectible. The type of the deduction, what's the character of the deduction? What's the character of the deduction when you have a business debt? Well, if it's a business debt, the deduction is ordinary loss, which is ordinary loss, which is good. It means you can deduct it against your ordinary income. That's great. If it's a personal loan, the loss, the type of the loss, the type of the deduction is a short-term capital loss, which is maxed at 3,000. What happened if you recover this money? Well, if you recover this money in the same year that you took the deduction, well, simply put, you reverse the entry and the problem is fixed. If you recover this money in subsequent year, if in prior year, and now the recovery is in this year, well, if in prior year and you receive the money now, you have to use the tax-benefit rule, which we talked about in a prior session. Simply put, you have to add this money to your income. Same thing with personal bad debt. If it's in the current year, you reverse the entry. If this is the prior year, if you took it out in the prior year, then you have to use the tax-benefit rule and it becomes, that amount becomes taxable. What should you do now? Go to far-hab lectures. You have to understand bad debt. You learn about bad debt in your financial accounting, where we use the allowance, allowance method. Well, for tax purposes, we cannot use the allowance method. We use the specific charge-off method or the specific write-off method, what it's called, the direct write-off method. What does that mean? It means if you have a receivable, you cannot project. You cannot project. Guess how much you're not going to be collecting? You have to wait until that becomes worthless. You determine this. How do you determine this? You tried every effort to try to collect the money and it did not help. Then what you do is you write off and take the deduction. Whether you are a CPA exam candidate, enrolled agent, or accounting student, go to far-hab lectures, look at additional MCQs, true-false, that's going to help you understand this concept. Good luck. Study hard and stay safe.