27 MAY 2024 WorldWide Drilling Resource® Drilling Into Money Not Boring by Mark E. Battersby Business Debts One of the most daunting four-letter words for the owner of any drilling operation - particularly those with smaller businesses - is “DEBT.” When a drilling operation finds itself dealing with the debts owed by another party, the tax rules, as complicated as they may be, can actually help. The tax rules recognize two types of bad debt deductions - business bad debts and nonbusiness bad debts. A business bad debt creates ordinary losses while nonbusiness bad debts give rise to shortterm capital losses. A business bad debt usually results from credit sales to customers for services provided or goods sold. Business bad debts can also take the form of loans made to suppliers, customers, employees, and distributors. A bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed and determinable amount of money. While some bad debts can be claimed as a capital loss, if the bad debt is a business bad debt, it’s only deductible as an ordinary loss. The drilling operation must be able to show it was the intent of the parties to create a debtor-creditor relationship, that the debt is legitimate and can’t be recovered from the creditor. To this end, there must have been a reasonable effort to collect the due amount. Unpaid invoices can be deducted as a business expense if they have already been included as income and so long as reasonable steps have been taken to collect the funds. For a sole proprietor selling services or goods on credit that eventually become worthless, a tax deduction is possible only if the amount owed was previously included in gross income. On the other end of the equation, for a troubled drilling operation or business, forgiveness of a debt generally produces taxable income. While there are some exceptions such as insolvency, drilling businesses operating as LLCs hold a unique position under our tax laws. LLCs are generally treated as a pass-through entity (unless there’s only one member in which case the entity is disregarded and taxes included on Schedule C of the individual’s Form 1040). Multimember LLCs, on the other hand, are passthrough entities. Incurring debt by a drilling operation can help with its growth. Should the operation’s debts be forgiven for one reason or another, the forgiven portion suddenly becomes income. Obviously, the tax treatment of debts requires both good records and professional guidance. Mark Mark E. Battersby may be contacted via e-mail to michele@worldwidedrillingresource.com
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