Michigan Treasury Issues an Advisory on Bad Debt Deduction Associated with Sales and Use Tax
The Michigan Department of Treasury updated its guidance on the sales and use tax bad debt deduction for periods after September 30, 2009. The revised release (Revenue Administrative Bulletin 2019-3) incorporates the Michigan Supreme Court’s 2018 decision in Ally Financial Inc. et. al. v. Department of Treasury.
In Ally Financial, the Court clarified that third-party lenders and retailers are entitled to bad debt deductions if the parties agreed to a split of their interest in the debt. The parties may allocate the debt between themselves consistent with their agreement – it is not an an-all-or-nothing issue for either the retailer or the lender.
Bad Debt Deduction for Sales and Use Tax
The bad debt deduction allows a taxpayer to claim a refund for sales and use tax that becomes worthless or uncollectible, or to deduct bad debts from its gross proceeds to compute sales or use tax liability.
A bad debt is any portion of a debt arising from a taxable retail sale that is eligible to be claimed (or would be eligible to be claimed) as a deduction under Section 166 of the Internal Revenue Code, if the taxpayer kept account on an accrual basis.
- Deduction Available to Retailers and Third-Party Lenders. For periods before September 30, 2009, the deduction is only available to retailers, but 2007 legislation expanded the deduction to include third-party lenders for periods on or after September 30, 2009.
- Lender Requirements to Claim Deduction. A third-party lender may claim the deduction if the retailer and lender timely execute and maintain a written election designating which party may claim the deduction. The lender must demonstrate that no deduction or refund was previously claimed or allowed.
- AR Must Be Worthless or Written Off. The taxpayer must demonstrate that the account receivable has been found worthless and is or was written off by the taxpayer that made the sale, or the lender designated to claim the deduction.
Bad Debt Defined
“Bad debt” is the part of a debt relating to a taxable sale at retail that is not otherwise deductible or excludable and which becomes worthless or uncollectible. The debt must be eligible to be claimed as a deduction as a bad debt for federal tax purposes.
Bad debt does not include:
- Interest or finance charges;
- Sales or use tax collected on the purchase price of the property;
- Uncollectible amounts on property that remain in the possession of the taxpayer until the full purchase price is paid; i.e., items placed on layaway;
- Expenses incurred while attempting to collect any account receivable or any portion of the debt that is recovered;
- Debts or accounts receivable that have been sold, assigned, or transferred to a third party lender; and
- The portion of the debt equal to the value of repossessed property (the amount collected); taxpayers may claim that bad debt deduction for the uncollected debt remaining after the sale of the repossessed property.
Here are some scenarios that illustrate the definition:
- Example 1. Acme Inc. is in the business of making retail sales. It financed sales for some of its customers and sold the debt in its entirety to Zenith Corp. Some of the customers fail to pay for the property, and bad debt is incurred. Acme may not claim a deduction for the bad debt.
- Example 2. Acme Inc. is in the business of making retail sales of vehicles. It sold a vehicle for $31,000 to John Smith and financed the sale. Smith paid off $1,000 in principal before making no further payments. Acme repossessed and sold the vehicle at auction for $20,000. Acme may not claim the bad debt deduction for the amount collected from the sale of the repossessed property at auction, but Acme may claim the bad debt deduction for the debt remaining after the repossession and sale ($10,000).
Requirements to Claim the Deduction
The bad debt deduction allows an eligible taxpayer to deduct bad debts from gross proceeds used to compute its sales and use tax liability. All of the following requirements must be met to claim the deduction:
- The amount of gross proceeds claimed as bad debt must be written off of the taxpayer’s books and records as uncollectible at the time the debt becomes worthless;
- The debt must be deducted on the return for the period the bad debt is written off as uncollectible in the taxpayer’s books and records; and
- The debt must be eligible to be deducted for federal income tax purposes.
If, after claiming the deduction, the taxpayer receives the entire payment of a bad debt, the taxpayer must remit on its next remittance to the Michigan Department of Treasury the taxes for which it had previously claimed the deduction.
If a partial payment is received, the taxpayer must proportionally apply the payment to the taxable price of the property – and the tax on the property before applying it to any interest, service, or other charge – and remit the appropriate tax to the Michigan Department of Treasury with its next remittance.
To demonstrate the application of the requirements, assume the same facts as Example 2 above. Acme must apply $18,868 of the proceeds from the auctioned vehicle to the price of the property and $1,132 to sales tax which must be remitted to the Michigan Department of Treasury. There would be no remaining proceeds applied to any interest, service, or other charges.
Entities that May Claim the Deduction: Retailers and Lenders
For bad debts incurred before September 30, 2009, the person who remitted the sales or use tax directly to the Department (i.e., the retailer) may only take the deduction. Lenders may not claim the deduction for bad debts incurred before that date.
The retailer must independently meet all of the statutory requirements to claim a bad debt deduction. For example, if a retailer sells the account receivable associated with the bad debt to a third-party lender, it may not claim the deduction because it did not write the bad debt off its books and records.
After September 30, 2009, either a retailer or lender may claim the deduction if these conditions are met:
- The retailer and lender execute and maintain a written election designating which party is entitled to take the deduction;
- No deduction or refund was previously claimed or allowed on any portion of the account receivable; and
- The account receivable is worthless and was written off by the taxpayer that made the sale or the lender on or after September 30, 2009.
- The written election must be executed before the bad debt deduction or refund is claimed.
Two examples to demonstrate the conditions:
- Example 4. Acme Inc., a retailer, and Zenith Corp., a third-party lender, sign a written agreement assigning Acme’s accounts receivable to Zenith for sales financed by Zenith. The agreement does not provide a written election specifying the party entitled to claim the Michigan bad debt deduction. Neither Acme nor Zenith may claim the deduction.
- Example 5. Acme Inc., a retailer, and Zenith Corp., a third-party lender, sign a written agreement on January 1, 2015, assigning Acme’s accounts receivable to Zenith for sales financed by Zenith. The agreement also provides a written election specifying that Zenith may claim the Michigan bad debt deduction. Zenith, but not Acme, may claim the deduction on claims made after January 1, 2015.
If you own or manage a retailer, lender, or other business and have questions about sales and use tax, bad debt deductions, or other tax liability, please contact us to discuss your situation.