Code Sec. 166, titled “Bad Debts,” generally controls who is entitled to a bad debt deduction and when a bad debt may be deducted. Sec. 166 conditions treatment generally on whether a bad debt is incurred in a trade or business. Further, Sec. 166 defers to Sec. 165 on the special treatment afforded to worthless securities (discussed earlier).
Non-corporate taxpayers cannot claim a bad debt deduction for non-business debts (debts not created in connection with, or whose loss is not incurred within, a trade or business). Instead, they may claim a short-term capital loss deduction, as if they sold or exchanged the debt or it became worthless and uncollectible – but not before then.
Sec. 166 allows taxpayers a deduction for completely worthless debt, debt which the taxpayer has no reasonable expectation of collecting. The deduction is equal to the taxpayer’s basis in the debt instrument. Sec. 166 also allows businesses a deduction for debt that becomes partially worthless. The taxpayer must prove to the satisfaction of the IRS that the debt is partially worthless. Additionally, the amount is limited to the total the taxpayer “charged off” during the year.