Most businesses will eventually encounter a customer debt that becomes wholly or partially uncollectible despite every effort to collect. While dealing with bad debts can be a nuisance, there’s a silver lining: in some cases, these losses can be deductible.
In this article, we’ll explain who can claim bad debt deductions, how the process works, and the steps you need to take to maximize these tax benefits.
Determining eligibility: accrual vs. cash accounting
Your business’s ability to claim a bad debt deduction depends on the accounting method you use.
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Cash accounting method: in cash accounting, income is recorded only when cash is received, and expenses are recorded only when they are paid. This method is straightforward and used by most small businesses for its simplicity.
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Accrual accounting method: in accrual accounting, income is recognized when it is earned, not necessarily when it is received, and expenses are recorded when they are incurred, regardless of when payment is made. This method can provide a more accurate picture of a business’s financial health by matching revenues with related expenses in the same period.
Bad debt deductions are relevant to those using the accrual method because, under this system, income from sales on credit is recognized when the sale occurs, not when the payment is received. If the debt later becomes uncollectible, a deduction is needed to adjust for the previously recognized income.
Some entities are required to use the accrual method by generally accepted accounting principles (GAAP). This includes larger businesses and those with inventory. However, the accrual method is also suitable for other types of businesses that deal with significant credit transactions or require a more detailed financial picture. Voluntarily using this method may benefit businesses that engage in complex transactions and long-term contracts, as well as professional service-based businesses with long billing cycles. It can provide a more comprehensive view of financial performance and aid in better decision-making and financial planning.
Conditions for claiming bad debt deductions
Business bad debts often result from credit sales to customers, but they can also arise from loans to suppliers, clients, or distributors. If any part of these receivables becomes uncollectible, it is classified as a business bad debt.
To claim a bad debt deduction, the IRS requires clear evidence that the debt cannot be collected. The following factors are typically considered:
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Efforts to collect: you must show that you’ve made reasonable attempts to collect the debt, such as sending reminders, making phone calls, and using collection agencies.
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Proof of worthlessness: you need to keep detailed records proving the debt is uncollectible. This can include correspondence with the debtor, records of collection attempts, and any legal actions taken.
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Timing: the debt must be deemed worthless within the tax year you claim the deduction. You must show there is no expectation of repayment during that year.
Partial bad debt deductions
Sometimes, a debt doesn’t become entirely uncollectible right away. Instead of waiting until the debt is fully worthless, you can deduct the partially uncollectible amount in the year it becomes evident that the debtor won’t fully repay.
To claim a partial bad debt deduction, you’ll need to identify an event that indicates the debt is unlikely to be fully repaid. Examples include a debtor declaring bankruptcy, selling their business, defaulting on repayment, or passing away with insufficient assets to repay the debt. Additionally, a clear refusal to repay the debt or a significant decline in the value of collateral can indicate partial worthlessness.
If the debt later becomes entirely uncollectible, you can still claim a deduction for the remaining amount. This approach allows you to get an early deduction for the partially uncollectible portion and ensures that you can deduct the total amount over time as it becomes fully uncollectible.
How it works
Consider ABC Corp., which sells $50,000 worth of goods to a client with terms of net 30. The client doesn’t pay on time, and the bill becomes overdue. ABC presses the client for repayment, and the client explains they are experiencing financial difficulties and can only repay $20,000.
Assuming there’s little likelihood of collecting the remaining $30,000, ABC Corp. claims a partial bad debt deduction for $30,000. To substantiate the deduction, ABC keeps records of all collection efforts and correspondence with the client.
The following year, the client manages to pay $10,000 out of the promised $20,000 but then files for bankruptcy. ABC obtains evidence that there is no likelihood of collecting the remaining $10,000 and claims an additional $10,000 bad debt deduction.
By claiming the partial bad debt deduction in Year 1, ABC reduced its taxable income sooner, improving its cash flow. When the debt becomes completely uncollectible in Year 2, ABC claims the remaining bad debt, ensuring the total uncollectible amount is deducted over time.
How to record and report bad debt deductions
Understanding how to properly record and report bad debt is crucial for maintaining adequate financial records and ensuring compliance with tax regulations.
How to track bad debts on your books
Bad debts should be recorded as an expense – a separate line item under operating expenses – and deducted from gross income to accurately reflect your net income.
For bad debts that are partially uncollectible, you need to re-evaluate the remaining portion of the debt each year. Adjust the deduction accordingly and report any changes in subsequent tax years.
An allowance for doubtful accounts, or bad debt reserve, is a useful tool for anticipating potential bad debts in your financial statements. The allowance is recorded at the same time as the sale, helping to prevent significant fluctuations in operating results when accounts become uncollectible. By maintaining this allowance, the write-off reduces the outstanding accounts receivable and is charged against the allowance, providing a more stable and predictable financial outlook.
It’s important to note that these allowances are not deductible for tax purposes. A tax deduction only arises when specific uncollectible items are identified and meet the criteria for bad debt deductions.
How to report bad debt deductions on tax returns
Corporations
For corporations, including LLCs taxed as corporations, with total assets of $10 million or more, bad debts should be reported on the bad debt expense line on the tax return and separately disclosed on Schedule M-3 (Net Income/Loss Reconciliation for Corporations With Total Assets of $10 Million or More).
For corporations, including LLCs taxed as corporations, with total assets under $10 million, bad debts can be reported on the bad debt expense line on the tax return.
Partnerships
Partnerships report bad debts on the bad debt expense line on the tax return.
LLCs taxed as pass-through entities
If the LLC is a multi-member pass-through entity, bad debts are reported on the bad debt expense line on the tax return. If the LLC is a single-member disregarded entity, bad debts are reported as an expense on Schedule C.
Sole proprietors
Sole proprietors report bad debts as an expense on Schedule C (Profit or Loss from Business).
General note on nonbusiness bad debts
Nonbusiness bad debts, which fall outside the scope of this article, are treated differently. Regardless of your business structure, nonbusiness bad debts are deducted as short-term capital losses on Schedule D of the appropriately filed return. It’s important to distinguish between business and nonbusiness bad debts to ensure they are reported accurately and in compliance with IRS regulations.
Recapturing paid debts
Writing off a debt as uncollectible doesn’t mean you must stop trying to collect it; businesses can and often do continue their collection efforts. Sometimes, a debt previously written off as uncollectible is unexpectedly repaid. When you recapture a previously deducted bad debt, the amount repaid must be reported as income in the year it is received. This is because the initial deduction reduces taxable income, and the repayment effectively reverses that benefit.
Ensure accurate reporting
To avoid issues with the IRS and ensure accurate reporting, follow these best practices:
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Maintain detailed records: keep thorough and organized records of all bad debts and related documentation, including loan agreements, collection efforts, and financial statements.
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Regularly review receivables: periodically review accounts receivable to identify potential bad debts early and take appropriate action. For partially worthless debts, be sure to reassess the remaining debt in subsequent years and adjust the status as needed.
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Consult a tax professional: seek guidance from a tax professional to ensure compliance with IRS regulations and to maximize the tax benefits of bad debt deductions.
Work with a professional for tailored guidance
Understanding how to account for bad debts is crucial for managing your business’s financial health. This overview provides a basic framework, but it is not a substitute for professional advice. To ensure you are maximizing potential deductions and adhering to IRS rules, contact one of our expert advisors today. They can provide tailored guidance and support for your specific circumstances.
