Bad debt write-off: what it is and when the IRS lets you deduct it

What is a bad debt write-off?

It is the step where you accept that a receivable won't be paid and take it off your books. In your accounts, the balance moves out of accounts receivable and into a bad debt expense. Writing it off doesn't cancel what the customer owes. It records that you no longer expect to collect it.

What is a business bad debt?

IRS Publication 334 defines it as a loss from the worthlessness of a debt that was created or acquired in your business, or closely related to your business when it became partly or totally worthless. It says business bad debts "are mainly the result of credit sales to customers." If you can't collect part of an account or note receivable, "the uncollectible part is a business bad debt."

Can you deduct a bad debt on your taxes?

Only if you counted the money as income first. IRS Topic 453 says you can deduct business bad debts "in full or in part, only if the amount you were owed is included in your gross income in the current or prior year."

Topic 453 adds that cash-method taxpayers generally can't deduct unpaid fees and similar items of taxable income.

When do you take the deduction?

Topic 453 says you take it "only in the year the debt becomes worthless."

Publication 334 covers two cases under the specific charge-off method:

• Partly worthless. You can deduct the part that became uncollectible during the year. The deduction is limited to what you charge off on your books that year. You can delay the charge-off to a later year, but not past the year the debt becomes totally worthless.
• Totally worthless. You deduct the whole amount minus anything deducted earlier as partly worthless. You don't have to charge it off on your books, though the IRS suggests you may want to.

Sole proprietors report business bad debts on Schedule C (Form 1040). Other businesses use their own business return.

What does this look like on a payment plan?

A worked example. A customer signs a $14,800 plan, pays the $1,500 deposit and five payments of $1,108.33, then stops. They have paid $7,041.65. Six payments are left: five of $1,108.33 and a last of $1,108.37, or $7,758.35.

• Accrual business that already recorded the $14,800 as income: if the $7,758.35 becomes worthless, it may be deductible as a business bad debt.
• Cash business: it only ever reported the $7,041.65 it received. The unpaid $7,758.35 was never income, so there is nothing to deduct.

What if the customer pays later?

Publication 334 says that if you deduct a bad debt and later collect all or part of it, you may have to include the recovery in gross income. The amount is limited to what you actually deducted. You can exclude the part of the deduction that didn't reduce your tax. Report it as "Other income."

What if you missed the deduction?

You can file a claim for a credit or refund. Publication 334 sets the deadline for a totally worthless debt at the later of 7 years from your original return's due date or 2 years from the date you paid the tax. For a partly worthless debt, it's the later of 3 years from filing or 2 years from paying.

General information, not legal or tax advice.