income claimed but will be lost

[Catherine]

New client has income "paid" by a prior employer (deferred, actually, but he claims he claimed it as income and paid tax on it in the year earned).  That company is now defunct, and he will never actually get the money.  

 

How does this get accommodated on a tax return?  Not one I've heard... amend the prior year as long as it's not out of statute?  If it is out of statute, then what?  Business capital loss, long-term (but it's not)?

 

TIA,

Catherine

[ILLMAS]

You can claim a business bad debt deduction only if the amount owed to you was previously included in gross income. This applies to amounts owed to you from all sources of taxable income, including sales, services, rents, and interest.

 

Accrual method.   If you use the accrual method of accounting, you generally report income as you earn it. You can only claim a bad debt deduction for an uncollectible receivable if you have previously included the uncollectible amount in income.   If you qualify, you can use the nonaccrual-experience method of accounting discussed later. Under this method, you do not have to accrue income that, based on your experience, you do not expect to collect.

 

Cash method.   If you use the cash method of accounting, you generally report income when you receive payment. You cannot claim a bad debt deduction for amounts owed to you because you never included those amounts in income. For example, a cash basis architect cannot claim a bad debt deduction if a client fails to pay the bill because the architect's fee was never included in income.

 

How To Claim a Business Bad Debt

There are two methods to claim a business bad debt.

• The specific charge-off method.

• The nonaccrual-experience method.

Generally, you must use the specific charge-off method. However, you may use the nonaccrual-experience method if you meet the requirements discussed later under Nonaccrual-Experience Method .

Specific Charge-Off Method

If you use the specific charge-off method, you can deduct specific business bad debts that become either partly or totally worthless during the tax year. However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the year.

Partly worthless debts.   You can deduct specific bad debts that become partly uncollectible during the tax year. Your tax deduction is limited to the amount you charge off on your books during the year. You do not have to charge off and deduct your partly worthless debts annually. You can delay the charge off until a later year. However, you cannot deduct any part of a debt after the year it becomes totally worthless.

Significantly modified debt.   An exception to the charge-off rule exists for debt which has been significantly modified and on which the holder recognized gain. For more information, see Regulations section 1.166-3(a)(3).

Deduction disallowed.   Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. If, under audit, the IRS does not allow your deduction and the debt becomes partly worthless in a later tax year, you can deduct the amount you charged off in that year plus the disallowed amount charged off in the earlier year. The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year.

Totally worthless debts.   If a debt becomes totally worthless in the current tax year, you can deduct the entire amount, less any amount deducted in an earlier tax year when the debt was only partly worthless.   You do not have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. However, you may want to do so. If you do not and the IRS later rules the debt is only partly worthless, you will not be allowed a deduction for the debt in that tax year because a deduction of a partly worthless bad debt is limited to the amount actually charged off. See Partly worthless debts, earlier.

Filing a claim for refund.   If you did not deduct a bad debt on your original return for the year it became worthless, you can file a claim for a credit or refund. If the bad debt was totally worthless, you must file the claim by the later of the following dates.

• 7 years from the date your original return was due (not including extensions).

• 2 years from the date you paid the tax.

  If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates.

• 3 years from the date you filed your original return.

• 2 years from the date you paid the tax.

You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. Such an impairment requires proof of existence.   For details and more information about filing a claim, see Publication 556. Use one of the following forms to file a claim. For more information, see the instructions for the applicable form.

[Catherine]

Thank you, ILLMAS --

 

That works for the loan he made to the business, and his investment in it as well -- but I don't see that this applies to deferred wage/salary income that was claimed, and taxes paid on it, and now cannot be received.

[ILLMAS]

Let's say the TP was supposed to be paid $50K for work, TP reported the $50K on Sch C and paid the tax, this will fall under:

 

Cash method.   If you use the cash method of accounting, you generally report income when you receive payment. You cannot claim a bad debt deduction for amounts owed to you because you never included those amounts in income. For example, a cash basis architect cannot claim a bad debt deduction if a client fails to pay the bill because the architect's fee was never included in income.

 

However, I would see it very tough convincing the IRS you accidentally reported income you have not received yet.

 

Or lets say the company who paid him the deferred wages (W2), the company paid the payroll taxes, TP reports it however he never received the actual pay, then his employer would have to to correct his W-2 to reflect zero wages.

[cred65]

How did he report it?  Was it schedule C, wages?