Help: client issued loan, accrued interest forgiven

[ell3brwns]

I've got a tricky situation and I could use some input from accountants here. I have a client, a small business, that issued a $2,000 loan to a supplier. The loan terms are unusual: there's a 72-month grace period where no payments are required, and the interest is compounding monthly. The catch is if the supplier pays off the $2,000 principal at any point before the 72 months are up, all the accrued interest is completely forgiven.

The supplier just paid off the loan in month 71. So, my client accrued and reported interest income on their books for 70 months, and as a result, they've been paying taxes on it. Now that the interest has been wiped out, what's the best way to handle this on their tax return? My gut says they can't be taxed on income they never received. Is the standard approach to treat the forgiven interest as a deduction or a negative income item to offset the previous years' reported income? Any advice on the proper accounting and tax treatment would be a huge help. Thanks in advance!

 

[Kurt Zamo]

That's a rather creative loan agreement your client put together. It's not every day you see terms like that. Your instinct is absolutely correct. You shouldn't end up paying tax on income that was never actually collected due to a contract provision. The most efficient and straightforward way to handle this is to take a deduction for the full amount of the previously accrued and taxed interest on this year's tax return. You wouldn't go back to amend the prior returns, because the income was reported correctly based on the facts at the time, and the forgiveness is the event that creates the deduction in the current period. I'm assuming your client has been filing on an accrual basis all along. Is that correct?