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California suspends and limits sales and use tax bad debt deduction
August 2024
Update: The California Department of Tax and Fee Administration issued guidance in September 2024 clarifying that the bad debt deduction will still be available for retailers after January 1, 2025. Lenders or affiliated entities will remain ineligible to receive bad debt deductions for all transactions after January 1, 2025.
In brief
What happened?
Budget-related tax legislation enacted in California on June 13, 2024, suspends the sales and use tax bad debt deduction beginning January 1, 2025; amends the retailer definition for purposes of the deduction to include affiliates through December 31, 2024; and reinstates the deduction on January 1, 2028, for retailers only.
[S.B. 167, enacted 6/13/24]
Why is it relevant?
For credit sales, a retailer or lender often must remit sales tax before collecting the price from the purchaser. If the purchaser defaults on its obligation, the retailer recognizes the expense for the uncollectible receivable by ‘writing off’ the debt on its federal income tax return.
States uniformly provide relief by allowing the retailer to recover excess sales tax paid on the sale, commonly known as a bad debt deduction. With the enactment of S.B. 167, retailers will be unable to recover the excess sales tax paid during the bad debt deduction suspension timeframe. Lenders will be unable to recover excess sales tax paid beginning January 1, 2025.
Actions to consider
Retailers, lenders, and retailers’ affiliates can claim the bad debt deduction for accounts charged-off up to and including December 31, 2024. Taxpayers should evaluate charge-offs taking place prior to January 1, 2025, to determine eligibility for the deduction.
In detail
Background
California statute allows a retailer relief from liability for sales and use tax that became due and payable, for accounts that have been found to be worthless and charged off for income tax purposes by the retailer or, if the retailer is not required to file income tax returns, charged off in accordance with generally accepted accounting principles [California Sections 6055, 6203.5].
A retailer that previously has paid the tax may take as a deduction from sales tax the amount found worthless and charged off by the retailer. "Retailer" includes any entity affiliated with the retailer. “Lender” means any person that holds a retail account (1) which that person purchased directly from a retailer who reported the tax, (2) pursuant to that person' s contract directly with the retailer that reported the tax, or (3) an affiliated entity or assignee of such person.
For accounts held by a lender, a retailer or lender is eligible for the deduction if making an election in which the retailer that reported the tax and the lender prepare and retain an election form, signed by both parties, designating which party is entitled to claim the deduction or refund.
Observation: A lender with the right to claim a bad debt deduction, regardless of whether the lender holds a seller’s permit for sales of tangible personal property, must register with the State Board of Equalization for a Certificate of Registration—Lender no later than the date on which it first claims a deduction or refund.
To claim the bad debt deduction, a retailer or lender must meet the following conditions:
- A deduction was not previously claimed or allowed on any portion of the accounts
- The accounts have been found worthless and written off by the lender
- The contract between the retailer and the lender contains an irrevocable relinquishment of all rights to the account from the retailer to the lender
- The retailer remitted the tax on or after January 1, 2000
- The party electing to claim the deduction or refund files a claim in a manner prescribed by the department.
Observation: When a retailer assigns its rights under a financing contract to a third party, the bad debt deduction can be claimed in a limited number of states.
If an account found to be worthless and charged off includes taxable and nontaxable receipts such as interest, insurance, repair or installation labor, the deduction may be claimed only for the unpaid amount upon which tax has been paid. A pro rata method, contract method, or another method that reasonably determines the amount of taxable receipts may be applied.
No deduction is allowable for expenses incurred by the retailer in attempting to enforce collection of any account receivable, or for that portion of a debt recovered that is retained by or paid to a third party as compensation for services rendered in collecting the account.
If worthless accounts are thereafter in whole or in part collected by the retailer, the amount collected must be included in the first return filed after the collection and the tax must be paid with the return [California Regulation Section 1642].
Non-retailer lenders’ deduction applies before January 1, 2025
S.B. 167 provides that before January 1, 2025, the "retailer" definition includes any entity affiliated with the retailer such as banks, credit unions, and other financial companies. When the bad debt deduction is reinstated January 1, 2028, the retailer definition no longer includes affiliates.
Observation: Starting January 1, 2025, the Governor’s Budget Summary stated that California joins most states that disallow the deduction for non-retailer lenders.
Action item: Lenders and affiliates should monitor eligible receipts and charge-offs through December 31, 2024, to deduct sales and use tax paid on worthless accounts.
Retailers’ deduction suspended until January 1, 2028
The enacted legislation suspends the bad debt deduction for retailers from January 1, 2025, until January 1, 2028.
Action item: Retailers and lenders should evaluate the implications of the disallowed deduction, including whether ASC 450 reserves calculations should be reviewed and amended.
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