Section 166(a) of the tax code says that "there shall be allowed as a deduction any debt which becomes wholly worthless within the taxable year." However, in the case of a guarantor of another party's debt, a special set of rules operates to determine the time such guarantor is entitled to a "bad debt" deduction (once the guarantor honors the obligation to the creditor).
Sec. 1.166-1 Bad debts.
(a) Allowance of deduction. Section 166 provides that, in computing
taxable income under section 63, a deduction shall be allowed in respect
of bad debts owed to the taxpayer. For this purpose, bad debts shall,
subject to the provisions of section 166 and the regulations thereunder,
be taken into account either as--
(1) A deduction in respect of debts which become worthless in whole
or in part; or as
(2) A deduction for a reasonable addition to a reserve for bad
debts.
The following case study is very useful :
ISSUES
1. What steps are necessary to record or memorialize the assignment of a loan
(or loan portion) as a loss asset for purposes of the conformity method of accounting
for worthless bad debts?
2. Does the conclusive presumption of worthlessness under the conformity
method apply to loans erroneously classified as loss assets?
FACTS
ABC corporation is a bank (as defined in 1.166-2(d)(4)(i) of the Income Tax
Regulations) and is subject to supervision by Federal authorities. ABC has elected
under 1.166-2(d)(3) to use the conformity method of accounting to determine when
debts owed to ABC become worthless bad debts.
Under a resolution adopted by ABCs board of directors, ABCs officers and
employees are authorized to charge off loans ( ...