Michigan: Taxpayer Failed to Substantiate Bad Debt Deduction

Listen to a brief overview of state tax developments this week, including Michigan, or read full Michigan development below.

Detailed Michigan Development

The Michigan Court of Appeals recently upheld the denial of a sales tax refund claim related to a bad debt deduction. The taxpayer at issue was a bank that offered private-label credit cards (PLCCs) to customers of various merchants. Certain of the transactions it financed were subsequently defaulted on by the PLCC holders, and the taxpayer wrote off those amounts for income tax purposes. Although the retailers remitted the sales taxes, Michigan’s bad-debt statute allows either the merchant or the lender to seek a tax refund. A lender seeking a tax refund must provide certain documents and support for its claim to the Department, including establishing that “no deduction or refund was previously claimed or allowed on any portion of the account receivable,” and the account receivable was found worthless and written off by the lender.  Further, per the statute any claim for a bad debt deduction must be supported by the evidence required by the Department. After the Department of Treasury denied the majority of the taxpayer’s claim due a lack of evidence that sales tax had actually been paid on the accounts written off, the taxpayer subsequently filed a complaint with the Court of Claims. The Court of Claims upheld the denial, and the taxpayer appealed.

The key issue before the appeals court was whether the taxpayer had provided sufficient evidence that the sales taxes were actually paid to the state by the merchants.  The taxpayer had obtained, from the merchants, the percentage of the merchants’ gross sales subject to Michigan sales tax. That percentage was then applied to the taxpayer’s written-off accounts, generating an estimate of the tax that might have been paid on the bad debt. In the court’s view, the Department correctly exercised its discretion when it determined that the taxpayer had not provided sufficient evidence to support its claim. The spreadsheets merely showed the amount of bad debt the taxpayer purported to have acquired and the estimated amount of taxes the  merchants might have paid in relation to that debt. The court also noted that the majority of accounts written off had been sold to third-party debt collectors which, under Michigan law, are excluded from the definition of “bad debt” entirely. The taxpayer argued that because Michigan allows repossessed property to reduce the value of the written-off debt by the value of the recovered property, the sale of the debt should reduce the value of the debt only by the consideration received from the third-party. The court disagreed, noting that the law was clear that any accounts receivable that “have been sold to and remain in the possession of a third party for collection” are excluded from the definition of “bad debt.”  The court therefore upheld the denial of the remainder of the taxpayer’s refund claim. Please contact Dave Perry at 513-763-2402 for more information on Capitol One, N.A., v. State Treasurer, State of Michigan and Department of Treasury.

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Featured Speaker

Sarah McGahan

Sarah McGahan

Managing Director, State & Local Tax, KPMG US