There are two types of bad-debts: business and non-business. A business bad debt expense arises from operating your trade or business, so it is pretty simple to spot. These deductions are deducted on Schedule C of an individual income tax return or on the applicable business income tax return. Most small business owners run into customer accounts that go unpaid. In the business context, bad debt is usually an account receivable – goods or services sold but not paid for yet – that is no longer collectible after a reasonable period of time. Fortunately, bad debt is one thing even the IRS will give you a break on. However, it is harder to get the deduction for non-business bad debts than business bad debts.
You can claim a business bad debt only if the amount owed to you was previously included in gross income. This creates a problem if your business uses cash method accounting. If you use the cash method, you generally report income when you receive payment. So, you can’t claim a bad debt deduction for amounts owed to you, because they were never included in income.
Under the accrual method, income is reported when you “earn” it, regardless if you received the cash. Thus, if the uncollectible amount was included in income, you could deduct the business bad debt. The bad debt may be claimed as an operating expense and simply subtracted from the business’ profits.
– Accounting Methods to Write-Off Bad Debt –
Generally, there are two bad debt write-off methods allowed under Generally Acceptable Accounting Principles (“GAAP”):
- direct write-off method
- allowance method (uses estimates)
Depending on which of the above methods are used to write off the debt, a journal entry is recorded on the accounting books for the business. Essentially, the entry is a reduction in the value of an asset (usually Accounts Receivable) by the amount of an expense or loss.
– Non-Business Bad Debt Deductions –
All other bad debts are non-business bad debts and are deductible only as short-term capital losses. The IRS allows you to deduct a non-business bad debt, but you must show that the debt is bona fide, meaning you made the loan with every expectation of being repaid. You have a basis in the debt, and the debt became totally worthless the year you are trying to claim the bad debt deduction. If the borrower files for bankruptcy, this is clear evidence you can’t be repaid.
– Proof of Worthlessness –
How to determine when an account receivable is deemed uncollectible is a fact-sensitive issue. The IRS requires that a taxpayer show with evidence and documentation that a debt is indeed worthless. Also, a taxpayer must exhaust all reasonable means of collecting the debt in order to prove its worthlessness. Basically, you will need evidence that there is no chance of the debt being paid for in the future. This typically means documentation of attempts to collect on the debt including phone records, copies of letters or notices and any legal action that you may have taken to pursue the customer or business.
If you’re wondering if you have some options in regards to declaring “bad debt” as we mentioned above, it is highly encouraged that you seek the advice of a knowledgeable attorney or accountant. EPGD Law has a wide network of professionals available at your convenience when requested. Contact us to schedule a consultation at (786) 837-6787 or firstname.lastname@example.org
*Disclaimer: This blog post is not intended to be legal advice. We highly recommend speaking to an attorney if you have any legal concerns. Contacting us through our website does not establish an attorney-client relationship.*