Many business debts can be claimed as tax deductions—if you’re careful.
By Mark E. Battersby
It’s not always possible to bring all customer accounts to zero, even after friendly attempts at collection. At that point, you have a choice: Write off the account as a bad debt or forgive the debt entirely. Each approach carries trade-offs.
Some small businesses simply forgive the outstanding debts of customers who may have fallen on hard times. Unfortunately, there is no tax deduction associated with this type of bookkeeping adjustment.
However, you may be able to deduct business bad debts as an expense on your business tax return. The debt must have been created or acquired in the normal course of business or closely related to the business when it became either partly or totally worthless. That usually includes services and goods that haven’t been paid for by customers.
Good bad debts
A bad debt is usually defined as an account or note receivable that has proven to be entirely or partially uncollectable. Just because something may be labeled as a business bad debt, however, doesn’t necessarily make it tax deductible.
A bad debt deduction can be claimed only if the amount owed was included in gross income for the year the deduction is claimed or for a prior year. This is almost never the case for cash method businesses (businesses that report income when it’s received). Accrual method companies, however, report income as it’s earned; if receivables have already been claimed as income, a bad debt deduction for uncollectible receivables is appropriate.
Business bad debts are usually the result of credit sales to customers. Goods and services that have been sold or provided but not yet paid for are recorded in the books as either accounts receivable or notes receivable. After a reasonable period of time, if attempts to collect the amount due are unsuccessful, the uncollectible portion becomes a business bad debt.
If a business guarantees a debt that subsequently becomes worthless, that debt can qualify as a business bad debt if all of the following requirements are met:
- The guarantee was made in the course of the trade or business.
- A legal duty to pay the debt exists.
- The guarantee was made before the debt became worthless. This requirement is met where there was a reasonable expectation that the debt would not have to be paid without full reimbursement from the borrower.
- If reasonable consideration for making the guarantee was received. This requirement is met if the guarantee was made in accord with normal business practice or for a good faith business purpose.
Generally, a debt becomes worthless when there is no reasonable expectation of payment. To show that a debt is worthless, a business must establish that it has taken reasonable steps to collect the debt. It is not necessary to go to court if it can be shown that a judgment from the court would be uncollectible.
Also, the deduction can be claimed only in the year that the debt becomes worthless. It is not necessary to wait until a debt is due to determine whether it is worthless. Bankruptcy of the debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.
Recovering bad debts
If a deduction for a bad debt is claimed on an income tax return and later all or part of the debt is recovered (collected), all or part of the recovery amounts may have to be included in the business’s gross income. Fortunately, the amount that must be included is limited to the amount actually deducted. The amount deducted that did not reduce the tax bill can usually be excluded.
Besides costing your business money, bad debts complicate accounting. When using accrual-basis accounting (as many
businesses do), income is realized at the time of sale, not when it is actually received. Because of the time lag as the nonpaid sale becomes an overdue account, many businesses go through various collection procedures, and the overdue account may eventually become a bad debt deductible on the business’s tax return.
For that to happen, the business must be able to show the debt is partially or totally worthless. Tax law doesn’t allow a deduction for any part of a debt after the year in which it becomes totally worthless. To ensure that your business doesn’t miss out on a bad debt deduction in the current tax year, records should be reviewed carefully to pinpoint any potentially worthless receivables still on the books. Make sure that all failed collection efforts are documented in case the Internal Revenue Service challenges the bad debt deduction.
This area of tax law requires substantiation, and can be tricky. If you have questions, check with your tax professional before assuming that a bad debt is tax deductible.