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Business bad debt deductions: the evidence a §166 workpaper has to carry

Reviewed 2026-09-15 · AI-assisted draft and editing; sources and limitations remain visible for independent review.

Answer: Section 166(a)(1) allows a deduction for any debt that becomes worthless within the taxable year, and section 166(a)(2) allows a partially worthless debt to be deducted in an amount not exceeding the part charged off within the year. Behind those two sentences sit five elements a file has to establish separately. There must be a bona fide debt, which Reg. §1.166-1(c) defines as one arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum, and which expressly excludes a gift or a contribution to capital. There must be basis, measured under section 166(b) by the adjusted basis used for determining loss on a sale, which is why Reg. §1.166-1(e) bars a deduction for unpaid wages, fees, rents and similar items unless the income was already included in a return. Worthlessness must be shown, and shown for the right year. The debt must be a business debt rather than a nonbusiness debt, since section 166(d) converts a nonbusiness debt of a non-corporate taxpayer into a short-term capital loss. And partial worthlessness requires an actual charge-off. Most denied write-offs fail on basis or on the year, not on the debtor's finances.

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Scope

Jurisdiction: United States — federal

Tax periods: Not period-specific; checked 2026-09-15

Assumptions

Exclusions

Element 1. A bona fide debt

Reg. §1.166-1(c) states the test compactly: only a bona fide debt qualifies, and a bona fide debt arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. The same paragraph rules out two things that are frequently written off anyway. A gift is not a debt. Neither is a contribution to capital, which is where advances to a controlled entity most often fail.

One sentence in that paragraph is a useful defense for accrual-method creditors. A debt arising out of the receivables of an accrual-method taxpayer is deemed an enforceable obligation to the extent the income it represents was included in a return for the deduction year or a prior year, and the regulation's own example is a gambling receivable unenforceable under state law but included in income under section 61. Enforceability under local law is therefore not always fatal.

The paragraph adds that the fact a debt is not yet due does not by itself prevent the deduction. What the file needs is the instrument or the account record, the terms, the stated sum, and evidence that both sides treated the advance as repayable at the time it was made rather than after collection failed.

Element 2. Basis, and the rule that ends most cash-method claims

Section 166(b) sets the amount of the deduction by reference to the adjusted basis provided in section 1011 for determining loss from a sale or other disposition, and Reg. §1.166-1(d)(1) repeats it. The consequence is blunt: a debt with no basis produces no deduction, however genuinely uncollectible it is.

Reg. §1.166-1(e) states the point that decides the most common real-world question. Worthless debts arising from unpaid wages, salaries, fees, rents and similar items of taxable income are not allowed as a deduction under section 166 unless the income those items represent has been included in a return for the deduction year or a prior year. A cash-method service provider that never billed into income has nothing to write off. This is not a documentation problem and cannot be cured with better collection evidence.

Reg. §1.166-1(d)(2) then limits specific cases. Where a taxpayer values notes or accounts receivable at fair market value when received, the deduction is limited to that value even if it is below face. A purchaser of receivables deducts by reference to the price paid, not face value. For a bankruptcy claim, only the difference between the distribution received and the amount of the claim is deductible. The same logic applies to a claim against a decedent's estate.

Element 3. Worthlessness, and the year it happened

Reg. §1.166-2(a) sets a general standard rather than a checklist: all pertinent evidence is considered, including the value of any collateral securing the debt and the financial condition of the debtor. Collateral is named first, and a secured position is often what defeats a write-off that the debtor's finances would otherwise support.

Reg. §1.166-2(b) removes one common obstacle. Where the surrounding circumstances indicate a debt is worthless and uncollectible, and legal action would in all probability not result in satisfaction of execution on a judgment, a showing of those facts is sufficient. Suing first is not required; documenting why suing would be futile is.

Reg. §1.166-2(c) handles bankruptcy and contains the timing trap. Bankruptcy is generally an indication of the worthlessness of at least part of an unsecured and unpreferred debt. But a debt may become worthless before a settlement is reached, and the regulation states that termination of the proceedings in a later year, confirming worthlessness, does not authorize shifting the deduction to that later year. The identifiable event that fixed worthlessness should be dated in the file, with the evidence available in that year, not the evidence that arrived afterwards.

Element 4. Business or nonbusiness

For a taxpayer other than a corporation, section 166(d)(1) turns off subsection (a) for a nonbusiness debt and treats the loss as a loss from the sale or exchange of a capital asset held for not more than one year. Section 166(d)(2) defines a nonbusiness debt as any debt other than one created or acquired in connection with the taxpayer's trade or business, or one the loss from whose worthlessness is incurred in that trade or business.

Reg. §1.166-5(b) supplies the test that actually gets applied. The question is one of fact in each case, and the character of the debt under the second limb is determined by the relation that the loss bears to the trade or business: if the relation is a proximate one in the conduct of the business in which the taxpayer is engaged at the time the debt becomes worthless, the debt is a business debt. The regulation adds two clarifications that cut both ways. The determination is made in substantially the same manner as under section 165(c)(1). And the use to which the debtor puts the borrowed funds is of no consequence, which disposes of the argument that a loan is a business debt because the borrower spent it on a business.

The examples in Reg. §1.166-5(d) trace a single receivable through a sale of the business, a sale of the claim alone, and two inheritances, and they show the pattern: the creditor's own position at the time of worthlessness, or at the time the debt was created or acquired, controls. A retired or non-operating holder of a business-origin claim can end up with a nonbusiness debt.

Element 5. Wholly or partly, and the charge-off

The two routes differ more than the statute's adjacent sentences suggest. Reg. §1.166-3(b) handles total worthlessness simply: where a debt becomes wholly worthless during the year, the amount not previously allowed is deducted for that year.

Partial worthlessness is narrower on three counts. Reg. §1.166-3(a)(1) allows it for specific debts only. Reg. §1.166-3(a)(2)(i) allows the worthless amount only to the extent charged off during the taxable year, so a book entry, not merely an opinion, is an element of the deduction. And Reg. §1.166-3(a)(2)(iii) requires the taxpayer to demonstrate both the amount that is worthless and the part that has been charged off, which are two different numbers that a file often conflates. Section 166(a)(2) is also permissive in its own words, allowing the deduction when the Secretary is satisfied the debt is recoverable only in part.

There is no partial route at all for a nonbusiness debt. Reg. §1.166-5(a)(2) provides that a loss on a nonbusiness debt is treated as sustained only if and when the debt has become totally worthless, and that no deduction is allowed for a nonbusiness debt recoverable in part. A non-corporate taxpayer holding a partially collectible personal loan therefore waits, whatever the book treatment.

Two procedural notes belong in the file, one of them with a caveat. Reg. §1.166-1(b)(1) states that a statement of facts substantiating any bad debt deduction claimed under section 166 shall accompany each return of income; that sentence sits in a paragraph about choosing between the specific charge-off method and the reserve method, and the reserve of former section 166(c) was repealed in 1986, so the paragraph around it is stale even though the sentence itself is still in the regulation. Under Reg. §1.166-1(f), a later recovery of a debt previously deducted is included in gross income for the year of recovery, subject to the recovery-exclusion rules, so a write-off is not the end of the account.

The workpaper outline

One page per debt, in this order. The instrument or account record, with the stated sum and terms, and the facts showing a debtor-creditor relationship at the time of the advance. The basis computation, with the year the underlying income was included if the debt arose from services, rent or a sale. The worthlessness narrative, dated, listing the identifiable events and the collateral position, and stating why collection efforts would be futile if none were made. The business or nonbusiness conclusion, tied to the creditor's own activity at the relevant time rather than the debtor's use of funds. The charge-off entry and its date if the claim is partial. Then the amount, and a note of any subsequent recovery.

A sibling page, 'Is it an ordinary and necessary business expense? A four-fork fact checklist', covers the general §162 substantiation forks; this page is about a deduction with its own statutory elements rather than those forks. To test a specific write-off, ask Taxterity a research question that states the origin of the debt, the year income was reported, and the events relied on for worthlessness, and verify each authority it cites against the current regulation before the return is signed.

Related research

Official sources

  1. 26 U.S.C. 166 — Bad debts (Office of the Law Revision Counsel) — 166(a)(1)-(2); (b); (c) [repealed 1986]; (d)(1)(A)-(B) and (d)(2)(A)-(B); (e); (f) cross references; prelim edition current through laws in effect September 14, 2026
  2. 26 CFR 1.166-1 — Bad debts (eCFR) — (b)(1) statement of facts with the return; (c) bona fide debt required; (d)(1) and (d)(2)(i)-(iii) amount deductible; (e) prior inclusion required; (f) recovery of bad debts
  3. 26 CFR 1.166-2 — Evidence of worthlessness (eCFR) — (a) general rule, collateral and debtor's financial condition; (b) legal action not required; (c)(1)-(2) bankruptcy and year of deduction
  4. 26 CFR 1.166-3 — Partial or total worthlessness (eCFR) — (a)(1) specific debts only; (a)(2)(i) and (a)(2)(iii) charge-off required and demonstration of amounts; (b) total worthlessness
  5. 26 CFR 1.166-5 — Nonbusiness debts (eCFR) — (a)(1)-(2) capital loss treatment and no partial deduction; (b) nonbusiness debt defined, proximate relation, and the use-of-funds sentence; (d) Examples 1-6

Limitations