Manufacturers & Distributors Deducting Partially or Wholly Worthless Bad Debts
Author: Tracy Madison
The current economic environment has increased the allowance for bad debt reserves on many manufacturers' and distributors’ balance sheets. The desire for customers to extend terms, along with an increased focus on credit risk, has provoked companies to more strongly evaluate the ability to collect on trade receivables. As a result, manufacturers' and distributors’ bad debt reserves and allowances have increased.
Often, the bad debt allowance on the balance sheet is assumed to be a nondeductible general reserve, so the deduction is disallowed as a temporary difference. However, Internal Revenue Code (IRC) Section 166 allows for a deduction of partially or wholly worthless bad debts. For wholly worthless bad debts, the deduction is allowed in the taxable year that debt becomes worthless. A partially worthless bad debt—a debt identified as recoverable only in part—can be deducted within that taxable year, not to exceed any amount charged off.
Necessary adjustments to the books to accomplish the charge-off of a partially worthless debt are not specified in the IRC or its regulations. A court decision in the Brandtjen & Kluge, Inc. v. Commissioner case provided that an effective charge-off is made if the adjustments eliminate the worthless portion of the debt from the taxpayer’s book assets. This could be accomplished by establishing a specific reserve separate from the general bad debt reserve. By analyzing the allowance for bad debts reserve, specific receivables identified as either wholly or partially worthless may be deductible, rather than treating the entire balance of the bad debt reserve as a nondeductible general reserve.
For manufacturers and distributors who previously had partially worthless bad debts included in their allowance for bad debts reserve, the IRS provides an automatic change in accounting method that allows for the deduction of partially or wholly worthless bad debts.
The ability to deduct partially or wholly worthless bad debts can provide real cash tax savings for manufacturers and distributors.
To learn more about deducting partially or wholly worthless bad debts, contact your BKD advisor.