A contractor writes off a $40,000 receivable, deducts the full country-club lunch that closed the deal, and expenses every mile on the truck. Three deductions, three different rule sets, and only one survives untouched.
A bad debt is an amount owed to the taxpayer that won't be collected. Under IRC §166, it's a business bad debt when the debt was created or acquired in the taxpayer's trade or business, or when its worthlessness is proximately related to that business. The label matters, because business and nonbusiness bad debts are deducted very differently:
- A business bad debt is fully deductible as an ordinary loss against business income.
- A nonbusiness bad debt is deductible only as a short-term capital loss, and only when it's totally worthless.
- A business bad debt may be deducted when it's only partly worthless, but the deduction is limited to the amount charged off on the books.
- Corporations are presumed to have only business bad debts.
- The deduction requires basis in the debt, meaning an amount the taxpayer already reported as income or actually lent.
Common mistakes
- Deducting a cash-basis receivable. A cash-method taxpayer has zero basis in an unpaid $18,000 invoice, because the fee was never reported as income. The bad debt deduction is $0, not $18,000.
- Treating a shareholder loan as ordinary. A $50,000 loan made to protect stock value is a nonbusiness debt. As a capital loss, it's capped at $3,000 of net capital loss per year against ordinary income.
- Adding gas to standard mileage. At 70 cents a mile, the rate already includes fuel, repairs, insurance, and depreciation. Only tolls, parking, and the business portion of interest and personal property tax are added.
Bottom line
- Business bad debts are ordinary and allow partial worthlessness; nonbusiness bad debts are short-term capital losses and require total worthlessness.
- Basis rule: accrual taxpayers can deduct unpaid receivables, cash-method taxpayers cannot.
- Business meals are 50% deductible in 2025; entertainment is 0%; employee parties and meals reported as W-2 wages are 100%.
- Business gifts cap at $25 per recipient per year, plus incidentals; $4 branded items and signs are exempt from the cap.
Exam shortcut
Read every deduction stem for the taxpayer's accounting method first. The words "cash basis" next to an uncollected fee mean the answer is zero, and a full-invoice distractor will always be offered. When a meal and an event appear together, split them: the event is zero, the separately stated food is half. If the stem says "not separately stated," the whole amount dies. For vehicles, ask three questions in order.
The full lesson (about 3,453 words, 23 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2
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