What method is required for deducting bad debts for tax purposes?

The method required for deducting bad debts for tax purposes is that debts can only be deducted when they become wholly or partially worthless. This approach aligns with the realization principle in accounting, where income and expenses are recognized based on tangible events rather than estimates or projections.

When a debt becomes worthless, it indicates that the likelihood of collection is negligible, allowing the taxpayer to recognize a loss for tax purposes. This process helps reflect the taxpayer's true financial position by taking into account only those debts that are certainly unrecoverable. The IRS requires documentation to substantiate the debt's worthlessness, which may include attempts to collect the debt or evidence of bankruptcy or insolvency of the debtor.

In contrast, the other options do not align with IRS regulations. Deducting a debt when paid (as suggested in one of the alternatives) is not consistent with the criteria for recognizing bad debts under tax law, as this method does not account for the potential loss until it is already paid. Similarly, deducting a debt upon default might suggest that any overdue account could be written off immediately without meeting the worthlessness criteria, which does not accurately reflect the taxpayer’s financial situation. Lastly, stating that debt can never be deducted is incorrect, as the tax code does allow for