If your business has already shown the expected revenue from that uncollectible debt, you may be able to reduce your business’s taxable income by the bad debt amount. Here’s how that works.
What’s Considered a Bad Debt?
Bad debt is owed by a customer, client, or patient that the business owner or creditor is not able to collect. You can write off bad debt on your business tax return, depending on your accounting method, as an expense of doing business. The Internal Revenue Service (IRS) says bad debts include:
Loans to clients and suppliersCredit sales to customersBusiness loan guarantees
How To Write Off Bad Debts
Bad debts are taken off the business income at the end of a year. In order to write off bad debts, your business must use the accrual accounting method. Under this method, you report the income in the tax year you earn it, regardless of when you actually collect the money or are paid. If your business operates on a cash accounting basis, you can’t deduct bad debts because in cash accounting, you don’t record the income until you have received the payment. In this case, you just don’t receive the income, so there is no tax benefit to recording a bad debt.
An Example of How Bad Debt Accounting Works
Let’s say you sell $1,000 of products to a customer. Here’s how and when to record the sale and whether you can deduct the bad debt. Under the cash accounting method, you only record the sale when you receive the money from the customer. If the customer doesn’t pay, you don’t record the sale. So, at the end of the year, if you haven’t been able to collect the money, there is no bad debt because there is no sale recorded. You can’t deduct the bad debt from your business income to reduce your taxes. Under the accrual accounting method, you record the $1,000 sale at the time you bill the customer. Your sales records for the year include this $1,000. If you determine that you are not going to be able to collect this $1,000 by the end of the year, you can manually take the amount out of your sales records before you prepare your business tax return.
How To Claim a Bad Debt Deduction on Your Business Tax Return
First, remember, you will need to run your business on the accrual accounting method to be eligible to take deductions for bad debt losses. There are two methods for claiming a business bad debt:
Specific charge-off methodNonaccrual-experience method
Generally, you’ll likely follow the specific charge-off method. There are specific rules for the nonaccrual-experience method and so only certain businesses qualify. See IRS Publication 535, Business Expenses to learn more. Prepare an accounts receivable aging report. This report shows all the money owed to you by all customers, how much is owed, and how long each customer’s debt has been outstanding (unpaid). Add up all bad debts for the year, evaluating each customer situation individually, based on your knowledge of the customer and the likelihood that they will pay. Create an accounting entry to reduce your accounts receivable and increase bad debt expenses for the total bad debts you have written off for the year. Include the bad debt total on your business tax return. If you file your business taxes on Schedule C, you can deduct the total of all the bad debts. Each type of business tax return has a place to enter bad debt expenses.
