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Chapter6_Lecture - Chapter 6 Losses and Loss Limitations...

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Chapter 6 Losses and Loss Limitations Bad Debts If an account receivable arising from credit sale of goods or services becomes worthless o A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income o No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected Business Bad Debts Specific charge-off method must be used o Exception: Reserve method is allowed for some financial institutions Deduct as ordinary loss in the year when debt is partially or wholly worthless o Cash basis taxpayer does not have bad debt deduction for unpaid receivables If a business debt previously deducted as partially worthless becomes totally worthless in a future year o Only the remainder not previously deducted can be deducted in the future year In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless Deductible amount depends on basis in bad debt o If debt arose from sale of services or products and the face amount was previously included in income That amount is deductible o If the taxpayer purchased the debt Deduction is equal to amount taxpayer paid for debt instrument If a receivable has been written off o The collection of the receivable in a later tax year may result in income being recognized o Income will result if the deduction yielded a tax benefit in the year it was taken Nonbusiness Bad Debts Nonbusiness bad debt o Debt unrelated to the taxpayer’s trade or business Deduct as short-term capital loss in year amount of worthlessness is known with certainty o No deduction is allowed for partial worthlessness of a nonbusiness bad debt Nonbusiness Bad Debts Related party (individuals) bad debts are generally suspect and may be treated as gifts o Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money
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o Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans Classification of Bad Debts Individuals will generally have nonbusiness bad debts unless: o In the business of loaning money, or o Bad debt is associated with the individual’s trade or business Determination is made either at the time the debt was created or when it became worthless Worthless Securities Loss on worthless securities is deductible in the year they become completely worthless o These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless Example of worthless securities o On December 1, 2008, Falcon Company purchased stock for $10,000. The stock became worthless on June 1, 2009. Falcon Company’s loss is treated as having occurred on December 31, 2009. The result is a long-term capital loss.
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