Guide to Deductible Business Expenses | Part 10: Bad Debt Deduction
If you missed the first nine parts of our guide to deductible business expenses, you can find them below:
Today’s topic may not be relevant to your business, depending on your business’s basis of accounting, or the method that your business uses to record revenue and expenses. Your business may employ an accrual basis or a cash basis of accounting.
Accrual-based businesses record revenue as it is earned, typically before any money has been exchanged; meanwhile, cash-based businesses do not document revenue until payment is in hand. Similarly, expenses are recorded as they are incurred using the accrual-based method, while businesses employing cash basis accounting wait until a bill has actually been paid to record it as an expense.
If you own an accrual-based business, you may be eligible to claim a bad debt expense deduction for accounts receivable that become partially or totally worthless during the tax year.
The term “bad debt” refers to an outstanding balance that is no longer considered recoverable. If a client or customer owes you money that you have been unable to collect, it is considered a bad debt. Bad debts may also result from loans to suppliers, employees, or distributors.
There are two types of bad debts: business bad debts and non-business bad debts. Business bad debts arise from the operation of a trade or business. If you are unable to collect money owed to your business, you have a bad debt, which you may be able to deduct as a business expense.
If you recorded the amount of the outstanding debt as part of your gross income (reporting it as income when it was billed rather than paid), you may be able to take a deduction for that amount. Eligible bad debt deductions can be taken in the current tax year even if the amount owed was included in a prior year’s reported gross income.
Because cash-based businesses record income as it is received rather than as it is earned, these businesses are generally ineligible for bad debt deductions.
What qualifies as a business bad debt?
A bad debt is a loss derived from the worthlessness of an outstanding balance deemed unrecoverable. In order to be considered a business bad debt, the debt must have been either acquired in the course of your trade or business or closely related to your trade or business when it became partly or totally worthless.
All bad debts of corporations (except for S corporations) are considered business bad debts.
There are various types of business bad debts, which may arise from situations such as:
Loans to clients and suppliers
Debts owed by political parties
Loan or capital contributions
Debts of an insolvent partner
Certain business loan guarantees
Sale of mortgaged property
What makes a debt worthless?
When there is no longer any chance that an owed amount will be paid, the debt becomes worthless and is therefore considered a bad debt.
In order to deduct a bad debt, you must be able to demonstrate its worthlessness by showing that you’ve taken every reasonable step to collect the debt. This may involve going to collections or taking the debtor to court, but you may be able to avoid going to court if you are able to show that a court judgment would be uncollectible. Proof of the debtor’s bankruptcy is generally accepted as proof of a debt’s worthlessness, either partially or in full.
What if I received property as partial settlement of a debt? Can I deduct the remainder of the debt as a bad business debt?
Possibly. If you’ve received property as partial settlement of a debt, you’ll first need to reduce the debt by the property’s Fair Market Value (FMV); if the remaining amount is considered worthless, you may claim that amount as a bad debt.
Can I claim a business bad debt deduction regardless of my accounting method?
No. Because your accounting method affects how you record income, it also affects whether or not an owed amount is considered a bad debt; you may only claim a business bad debt deduction if the amount owed was previously included in your business’s gross income.
If you operate your business using the cash method of accounting, income isn’t recorded until it is received. Therefore, you cannot claim a business bad debt deductions; outstanding amounts owed to you were never included in your recorded income.
However, businesses that use an accrual method of accounting may claim a bad debt deduction as long as the debt amount was previously recorded in income.
How do I claim a business bad debt deduction?
As discussed previously, cash-based businesses are not eligible for this deduction. However, if you have an accrual-based business, talk to your CPA about claiming this deduction.