Despite your best efforts to work only with customers or clients you believe will pay for the goods or services your business provides and to diligently collect delinquent amounts owed, you will almost inevitably have to deal with bad debts occasionally. Sometimes, the IRS allows you to take a bad debt deduction.

What Is Considered a Business Bad Debt?

According to the IRS, a business bad debt is considered a loss incurred from the worthlessness of a debt created or acquired in a trade or business or was “closely related” to your trade or business when it became partly or completely worthless. If your primary motive for incurring the debt was related to the business, the IRS will consider the debt to be closely related to the business.

The IRS provides these examples of bad business debts: (1) loans to clients, suppliers, distributors, and employees, (2) credit sales to customers, or (3) business loan guarantees. For small businesses, the most common bad debt arises from credit sales to customers.

If the circumstances indicate that your business has no reasonable expectation that the debt will be repaid, it will be considered worthless. Depending upon the facts, this could be on the date the debt is due or even before that date.

You must be able to demonstrate that you have made a reasonable effort to collect what is owed to your business before being eligible for the deduction. What is considered “reasonable” will vary depending upon the business in which you are engaged. It is unnecessary to sue the customer if you can show that a judgment would be uncollectible. For example, if the customer has filed for bankruptcy, this will demonstrate that your debt is uncollectible and therefore worthless (assuming it is an unsecured debt).

Your Accounting Method Matters

If your small business uses the cash method of accounting, which is often preferred because it is less complicated than the accrual method, you report income during the year it is actually received. Because you have not reported amounts you merely expect to receive, but only those you have actually received, you cannot receive a tax deduction based on a bad business debt. Only businesses that use the accrual method of accounting—which reports income in the year earned despite not having been received—may claim a deduction based upon a bad debt. This is because under the accrual method, a business never actually received the income reported to the IRS because of the customer’s failure to pay for the goods or services provided by the business. This does not provide an unfair advantage to businesses using the accrual method. Rather, it simply ensures those businesses are not paying taxes on income reported but never actually received.

Note: The deduction is available only in the year the debt becomes worthless.

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If your small business has suffered losses because of bad debts, and you are wondering if you may write them off, we can help you navigate the tax rules to minimize your tax liability, and provide guidance about steps you can take to avoid losses from bad debts. Please call us to set up a meeting.

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