Section 166(a) of the tax code states that "any debt which becomes completely worthless within the taxable year shall be allowed as a deduction." However, in the case of a guarantor of another party's debt, a special set of rules operates to determine when that guarantor is entitled to a "bad debt" deduction (once the guarantor honors the obligation in towards the creditor).Sec. 1.166-1 Bad debts.(a) Deduction allowance. Section 166 provides that, in computing the taxable income under section 63, a deduction is allowed in respect of bad debts owed to the taxpayer. For this purpose, bad debts, subject to the provisions of section 166 and the rules thereunder, shall be taken into account as: (1) A deduction against debts which become worthless in whole or in part; or as (2) A deduction for a reasonable addition to a bad debt reserve. The following case study is very useful: PROBLEMS1. What steps are required to record or recall the disposal of a loan (or a portion of the loan) as a loss-making asset for the purposes of the compliance method for accounting for worthless bad debts? Does the conclusive presumption of futility under the compliance method apply to loans incorrectly classified as loss-making assets? FACTSABC is a bank (as defined in 1.166-2(d)(4)(i) of the Income Tax Regulations) and is subject to the supervision of federal authorities. ABC has elected pursuant to Section 1.166-2(d)(3) to use the compliance accounting method to determine when debts owed to ABC become worthless bad debts. Under a resolution adopted by the ABC Board of Directors, ABC officers and employees are authorized to charge off mortgages (or portions of mortgages) only when write-off is required under the authority's credit loss classification standards. of banking supervision. Therefore, when ABC officers and employees charge off a loan for regulatory purposes, they take no additional steps to record or recall whether, in their judgment, the charge is required by the loan loss standards issued by ABC's regulator. .Loan loss standards require ABC to offset loss-making assets. Loss-making assets are loans (or portions of loans) that are deemed uncollectable and of such little value that their preservation as bankable assets is not guaranteed. In the case of a consumer loan or credit card debt, regardless of whether there is specific negative information about the borrower, ABC is required to charge off the asset when its default exceeds certain established thresholds.