Bad debt occurs when one party loans another party money, but the borrower fails to repay the loan according to the loan agreement. For example, if the borrower (or “debtor”) fails to keep up with monthly payments, or fails to pay back the loan altogether, the debt becomes “bad debt”. 

Bad debt can be problematic for both business and non-business lenders.  Rather than providing the lender (or “creditor”) with return on the amounts they have lent, a bad debt situation can stall income and create further financial and legal issues. It can lead to additional expenses incurred trying to recover the amount lent, called “collection”. 

Thus, it is important to have a debt agreement clearly spelled out in writing in order to avoid misunderstandings and disagreements between the parties. It is also helpful for collection efforts to have a contract that spells out the obligations of both parties and the options in the event of non-payment by the debtor. A well-written contract can also help in the event the creditor must go to court to collect the amount owed by the debtor.

What Are Some Legal Issues Related to Bad Debt?

Lenders should be aware of a few legal issues that may be related to bad debts. Some of these can include:

  • Tax consequences: Bad debt can sometimes be deducted from taxable income when the creditor prepares its tax returns. A business bad debt is a debt that was created in the course of operating a business or a trade; or, it was closely related to a business or trade when it became partially or totally worthless; it can be deducted from the gross income when calculating its taxes; some examples of business bad debt are:
    • Loans to clients, suppliers, distributors, and employees;
    • Credit sales to customers, 
    • Business loan guarantees.

Non-business bad debt has to be completely worthless to be deductible. That would mean that there is no hope of collecting the debt. A person would want to consult with an experienced tax attorney about the details of deducting bad debt on tax returns.

  • Bankruptcy: Filing for bankruptcy can sometimes have the effect of releasing a debtor from their debt completely. Of course, some kinds of debt are non-dischargeable in bankruptcy; a creditor may want to consult with an experienced bankruptcy lawyer in order to find out what their options are in the event a debtor declares bankruptcy. The creditor may want to find out if any debts are or are not dischargeable and whether it would be wise to settle with a debtor for an amount less than the full amount that is owed. There might also be timing issues concerning whether to settle with a debtor before a bankruptcy filing or after.

Also, the law regarding debt and debt collection often overlaps with other areas of the law, including contract law and consumer protection law. To add to the complication, both federal and state law may apply to any given situation. A creditor may need the services of an experienced lawyer when dealing with bad debt situations that are particularly complex. 

What If I Have a Legal Dispute Over Bad Debt?

A creditor who is owed money as a result of a legal lending transaction has the right to collect the money, especially if the debt arises from an enforceable written contract. If referring to the contract does not resolve the problem, a creditor may have a number of options:

  • Discharge of debt: sometimes a partial discharge of debt may help the debor to regain financial footing, a debtor might be able to achieve this by filing for bankruptcy. Prior to filing for bankruptcy a creditor might be contacted by a debtor or the representative of a debtor; they may ask the creditor to accept proposals to offer debt relief to debtors who are experiencing financial hardship. The benefits sought may include lower interest rates on the debt, a waiving of late fees and penalties, and even monthly payments that are more affordable. These types of requests are likely to come from consumer debtors who owe credit card debt and the like. A creditor may want to consult an experienced bankruptcy lawyer in order to get advice about whether it is more advantageous to accept such proposals than it is to drive a debtor into bankruptcy;
  • Modify or cancel the person’s debt: A creditor may always enter into a debt cancellation or debt modification agreement, especially for old or outdated debt.The creditor might take a financial loss by writing off the debt. This might help preserve good business relations with the other party; taking this step might be advisable if it is unlikely that the money owed will ever be recovered and continuing to incur expenses to collect the debt is probably futile;
  • File a lawsuit: A creditor may be able to file a complaint seeking to recover the money owed; if the creditor wins a judgment against a debtor, they may be able to then enforce the judgement through garnishment or levy on the debtor’s property. Or, a creditor may be able to place a lien on the person’s property to satisfy the debt; then if the property is sold, the creditor will be paid from the proceeds of the sale.

Again, it is helpful in connection with a bad debt claim to have a valid contract for the debt agreement. Without a contract, it might be challenging to have one’s collection rights enforced in a court of law. The contract needs to be clearly written and should satisfy the legal requirements for a valid contract

Another option that a creditor always has is to hire a collection agency to try to collect the money owed by the debtor. Some factors to consider when hiring a collection agency to recover bad debt are:

  • Specialization: with what kind of debt the collection agency usually deals; 
  • Legitimacy: whether it is bonded, licensed, insured and guarantees compliance with all applicable laws, e.g. the Fair Debt Collection Practices Act;
  • Skip-tracing: whether it can do skip-tracing, i;e; does it have access to databases that would allow it to find debtors who may have left town with no forwarding address;
  • Proof of Errors and Omissions Insurance: a creditor should get proof that the collection agency has “Errors and Omissions Insurance” in the event the agency does something it should not and is sued by the debtor. 
  • Compare fees: A collection agency might charge a flat fee; the flat fee is usually fairly small; the creditor wants to be sure to understand exactly what steps are included in the flat fee services; 

Another type of fee arrangement is a contingency fee; under a contingency fee arrangement, the collection agency will take a percentage of the amount it collects, such as 25% or 45% of the depending on the specifics of the account that is being collected; factors that affect the percentage include such items as how old it is, how many contacts have been made, and the like.

Keep in mind that hiring a collection agency is not a guarantee that the money owed will be collected in full along with the costs of collection.  A creditor may well receive only partial payment of the amount owed. For this reason, it might be advisable to take certain basic steps, such as sending the debtor a demand letter for payment before hiring a collection agency.  .

Do I Need a Lawyer for Assistance with Bad Debt?

Bad debt can present various difficulties for both parties to the agreement. If you are facing a situation involving bad debt, you may wish to speak with a lawyer who is experienced in collecting bad debt immediately. 

Your attorney can help you file a claim or take other steps so that you can obtain legal relief. Also, you may wish to hire an experienced collection lawyer before you enter into a debt or lending agreement. Your attorney can help you draft and review the contents of the contract so that disputes can be avoided in the first place. 

If you have been unable to collect on a bad debt, whether partially or in full, an experienced tax attorney may be able to help you claim a deduction on your tax returns.

There are many angles to bad debt and it is advisable to have an experienced lawyer helping you to come out ahead.