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J.K. Lasser's Small Business Taxes 2013: Your Complete Guide to a Better Bottom Line by Barbara Weltman

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Bad Debts in General

If you cannot collect money that is owed to you in your business, your loss may be deductible. You must prove 3 factors to establish a bad debt:

1. The debtor-creditor relationship
2. Worthlessness
3. Loss

The Debtor-Creditor Relationship

You must prove that there is a debtor-creditor relationship. This means that there is a legal obligation on the part of the debtor to pay to the creditor (you) a fixed or determinable sum of money. The legal obligation can arise from making a loan or selling goods and services.

If you lend money to a friend or relative, the relationship between you and the borrower is not always clear. You may, for example, lend the money with the expectation of receiving repayment but later forgive some or all of the payments. This forgiveness with a friend or relative transforms what might have been a bad debt into a gift. The law does not bar loans between relatives or friends, but be aware that the IRS gives special scrutiny to loans involving related parties.

The simplest way to prove a debtor-creditor relationship is to have a written note evidencing the loan. The note should state the following terms:

  • The amount of the loan
  • A stated rate of interest
  • A fixed maturity date
  • A repayment schedule

If you have a corporation to which you lend money, establishing the debtor-creditor relationship is crucial. Unless you can show that an advance to the corporation is intended to be a loan, it will be treated as a contribution to the capital ...

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