There are two methods to account for bad debt:
A receivable which is not considered collectible is charged directly to the income statement.
An estimate is made at the end of each fiscal year of the amount of bad debt. This is then accumulated in a provision which is then used to reduce specific receivable accounts as and when necessary.
A debt is defined as a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a determinable sum of money. The debt in question must also be considered worthless. This distinction is further broken down into the level of collectibles. One must determine whether the qualifying debt is completely or partially worthless. A partially worthless status means a portion of the debt may be recovered in future periods. Numerous factors are taken into consideration including the debtor’s insolvency status, health conditions, credit standing, etc.
Section 166 does limit the amount of deduction allowed. There must be an amount of tax capital, or basis, in question to be recovered. In other words, is there an adjusted basis for determining a gain or loss for the debt in question.
An additional factor in applying the criteria is the classification of the debt (nonbusiness or business). A business bad debt is defined as a debt created or acquired in connection with a trade or business of the taxpayer. Whereas, a nonbusiness debt is defined as a debt that is not created or acquired in connection with a trade or business of the taxpayer. The classification is quite significant it terms of the deductibility. A nonbusiness bad debt must be completely worthless in order to be deducted. However, a business bad debt is deductible whether it is partially or completely worthless.