How To Use Bad Debt Deductions To Reduce Business Taxes

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Being in business is hard work, especially when it comes to trying to collect money from customers. Sometimes people just won't pay for the service or product you have provided. No matter how many statements you send out, even if you take the customer to small claims court, you may not get your money. This is known as bad debt.

If your business has already shown the expected revenue and that debt owed to you from a customer later becomes uncollectible, you may be able to reduce your business income and taxes by the bad debt amount. Here’s how that works.

Key Takeaways

  • You may be able to deduct bad debt from your business income to reduce your taxable income.
  • You can only take a bad debt deduction if you use the accrual accounting method. 
  • The best time to write off bad debt is at the end of your fiscal (financial) year when you are sure certain debtors aren’t going to pay.
  • Report the total of all the bad debts on your business tax return as an expense of doing business.

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 suppliers
  • Credit sales to customers
  • Business 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.

Note

Most small businesses use the cash accounting method, unless they have inventory or in some other special circumstances.

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.

Note

The money owed to your business by customers is referred to as accounts receivable. It’s included on your business balance sheet as an asset because it has value. 

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 Tax Deduction for Bad Debts 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.

Note

You should wait until the end of the year to deduct these bad debts. If someone pays after the end of the year, you must reverse the accounting entry, a complicated process. 

There are two methods for claiming a business bad debt: 

  • Specific charge-off method
  • Nonaccrual-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 will 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). 

Total 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. 

Do 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.

Note

If you didn’t deduct a bad debt from your original business tax return, you can file a claim for a credit or a refund. See IRS Publication 556 to learn more about the process.

Frequently Asked Questions (FAQs)

How are bad debts accounted for?

Each time you record a sale and it hasn’t been paid, you have an account receivable on your balance sheet, if you use accrual accounting. Accounts receivable are unpaid amounts by customers or clients. At the end of the year, you must look at all accounts receivable to see which you think aren’t going to pay you. This total becomes the total bad debt expense you can deduct on your business tax return.

How do you report a bad debt to a credit bureau?

Individual businesses usually don’t report bad debts directly to a credit bureau, like Equifax or Transunion. The only way the information on a debtor gets to a credit bureau is if you take someone to court and win the judgment against them. This information goes into the public record and then credit bureaus access the information.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. IRS. "Topic No. 453 Bad Debt Deduction."

  2. IRS. "Publication 538 Accounting Periods and Methods."

  3. IRS. "Publication 535, Business Expenses."

  4. Board of Governors of the Federal Reserve System. "Credit Reports and Credit Scores."

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