Business owners often struggle to receive the money they've earned, but the potential tax benefit offers a silver lining. This primer will define bad debt, explain when bad debts generate a tax deduction, and show how to claim a bad debt write off.
hat is bad dDebt?
Bad debt refers to any amount owed to you that you will never be able to collect. A late payment or refusal to pay does not necessarily lead to a bad debt. The debt must become uncollectible in the foreseeable future as well—this can mean a bankrupt debtor, a customer you've unsuccessfully tried to sue, or a company in such bad financial shape that it has no assets for a court to seize.
Bad debts come in business and nonbusiness varieties
Nonbusiness bad debts only qualify for capital loss treatment—meaning they can only offset capital gains and up to $3,000 of ordinary income per year. You can carry forward nonbusiness bad debts if you can't use them in the current year. Also, only completely worthless nonbusiness bad debts qualify for a deduction—partially worthless debts don't count.
Business bad debts offset ordinary income. A debt created or acquired in a trade or business—or with a business-related primary purpose—counts as a business bad debt. Examples include credit sales to customers, loans to suppliers and employees, and business loan guarantees. Bad debts of a C corporation automatically qualify as business bad debt.
Can businesses take a bad debt write-off?
The tax treatment of a business's bad debt depends on whether your business uses the cash or accrual method of accounting for tax purposes. Cash method businesses record revenue when they receive cash, regardless of when they earn the revenue. Accrual method companies record revenue when they earn it, regardless of when they receive cash. Most small businesses use the cash method, but this can vary, so check with your accountant or tax preparer if you aren't sure.
Cash method businesses cannot deduct bad debts from credit sales to customers, which are the most common business bad debt. Cash method companies only recognize income when they receive payment, so if they never receive payment, they report no income from the transaction in the first place. Claiming a deduction for bad debt on income they never recognized as revenue would create a double benefit, so cash method businesses cannot do so.
However, if a cash method company incurs bad debts from other sources—such as loans—it can deduct the loss. In this case, the business had an actual outlay of cash that the debtor never repaid.
Accrual method companies can deduct bad debt provided they previously included it in their income. Accrual method businesses report income as they earn it, so they can deduct bad debt on credit sales to customers.
Accrual method service providers in specific fields—such as law and accounting—can exclude from income the portion of revenue they won't collect based on prior experience. These companies reduce their revenue rather than writing off specific bad debts. Businesses must stay under a gross receipts threshold to use this method, which comes with its own accounting rules.
How to take a bad debt write-off
Companies write off or deduct business bad debts in the year they become worthless. This occurs when the business no longer reasonably expects payment on the debt.
The IRS distinguishes between totally worthless and partially worthless debt. Partially worthless debt arises when the business can't reasonably expect to collect the entire debt in the future but still hopes to recover part of the money owed. Companies can't deduct more than they write off on their accounting records for partially worthless debt.
Sole proprietorships write off bad debts on line 27a of Schedule C, Profit or Loss From Business. Partnerships use line 12 of Form 1065, U.S. Return of Partnership Income. Bad debt deductions for S corporations go on line 10 of Form 1120-S, U.S. Income Tax Return for an S Corporation. C Corporations report bad debt expenses on line 15 of Form 1120, U.S. Corporation Income Tax Return.
Understanding which bad debts qualify as business bad debts and when companies can write off bad debt allows your business to claim any available bad debt deduction.