Charged off account

Chargeoff doesn't necessarily mean that it was sent to a collections agency. A chargeoff just means the original creditor has deemed it as bad debt, and it is no longer an asset on their financial statement. They can still own the debt and try to collect on it, or they can sell it.

When I chargeoff an account, I keep it in a file cabinet behind my desk... I have never sold one of my accounts or sent them off to a collection agency. Once or twice a year I go through old chargeoffs, make some phone calls, and get lucky on some of them that want it off their credit.

DebtCruncher, help me to understand how that happens with regard to your business taxes. I thought once you reported the chargeoff and used it in your taxes as a deduction, it couldn't be pursued because it would be result in a double benefit if you collected on it. I'm not a tax person but I'm interested in learning how it works.

Keep in mind the general accounting equation A (ssets) + L (iabilities) = OE (Owner's Equity).

Contract receivables sit on the books as an asset, just like a checking account. When I give out a $10,000 car loan, I am taking a $10k liquid asset (cash) and turning it into a $10k semi-liquid asset (installment contract). The net effect on my balance sheet is zero. As a customer makes payments, they liquidate that contract back into cash.

Our problem comes in when an account defaults and stops paying. This becomes bad debt. If we leave it on our books, it basically becomes an "imaginary" asset. We can call it an asset, but if we can never liquidate it then we are just kidding ourselves and our investors. It's kind of like saying "I have a $10k check in the bank, it just hasn't cleared yet and we don't know if it ever will." At some point you have to cut your losses and stop counting it as an asset, that way our books will reflect our true financial position.

On the accounting side, it gets a little complicated because we have this account called a loss reserve. A loss reserve it a way of controlling/estimating your writeoffs in advance. Basically, if I have a million dollars worth of loans (assets), I might estimate that we will have to writeoff $200k over the course of the year. So I setup a loss reserve of $200k and tie that to my contracts account. When I look at my balance sheets, it will show $1million in loans, less $200k reserve for bad debt = $800k net contracts receivable. ... $200k/12 = $16,666/mo, so my direct expenses will show a steady $16,666 per month bad debt expense, regardless of what accounts I actually charge off during the course of the year. (It's really not that simple, but I use this just so you can get the idea.)

When we chargeoff an account, we are not directly expensing it as bad debt. Rather, we are charging it against our loss reserve. Hence why it is called a chargeoff and the description on your credit report says, "charged off as bad debt". Not forgotten, just charged against a contra-account for accounting purposes.

Getting to your main question... the $ amount of writeoffs on our income statement is really kind of an imaginary number that is based on ratios, calculations and past performance. We don't specifically claim it as a deduction for tax purposes; it simply becomes a part of our income statement and offsets our overall income. We pay taxes on the amount of income that we show.

Now, after an account has been charged off, it is still a legal debt. We can perform collection activites and try to recover it. If we can recover it and get some money, then it becomes "recovery income" and would be reported on our income statement the year we receive it. In essence, we would end up paying tax on a chargeoff after we actually get paid on it.

There is this thing called cancellation of debt, which is completely different than a chargeoff. This may be what you are thinking of.... Cancellation of debt is pretty much a creditor erasing a debt and never being able to recover it again. Take a settlement on your credit cards-- If you owe $2000 on a credit card, and you can call up and get them to "settle" for $1000, then there is cancellation of debt to the extent of $1000 because they can not attempt to recover that portion in the future.

Any cancellation of debt over $600 must be reported to the IRS. But it is not the creditor making money, it the debtor who benefits from a cancellation of debt. If you owe me money, and I cancel YOUR debt, then I send in a 1099-C to the IRS and YOU have to report it as income, and YOU have to pay taxes on it.

A little lengthy, but I hope it explained things. Any other questions?

It took me so long to write that, that the system logged me out and I ended up posting that as guest. ... I was wondering why it didn't give me any points.

Thanks for all of your help.