How Bad Debt Is Defined for Accounting and Taxes

Bad debt represents money owed to a business or individual that is unlikely to be collected. This occurs when a debtor cannot or will not pay, resulting in a loss for the creditor. Managing and accounting for uncollectible amounts ensures accurate financial reporting and proper tax treatment.

General Accounting Definition

In financial accounting, bad debt refers to uncollectible accounts receivable. Businesses extend credit to customers, expecting payment in the future, but sometimes these expectations are not met. Recognizing bad debt aligns with the matching principle, which requires expenses to be recorded in the same period as the revenues they helped generate.

To account for uncollectible receivables, companies primarily use two methods. The direct write-off method recognizes bad debt expense only when a specific account is identified as uncollectible. This approach directly removes the uncollectible amount from accounts receivable and records it as an expense. However, this method is not accepted for financial reporting under Generally Accepted Accounting Principles (GAAP) because it violates the matching principle.

The allowance method, conversely, estimates uncollectible accounts and establishes an allowance for doubtful accounts at the end of each accounting period. This contra-asset account reduces accounts receivable to their net realizable value, which is the amount the company expects to collect. This method adheres to GAAP by estimating bad debt expense in the same period the related revenue was earned, providing a more accurate reflection of a company’s financial position.

Business Versus Non-Business Bad Debt

For tax purposes, the Internal Revenue Service (IRS) distinguishes between business and non-business bad debts, impacting their deductibility. A business bad debt is a loss from a debt created or acquired in a trade or business, or one closely related to it, that becomes worthless. Examples include uncollected credit sales to customers, or loans made to clients, suppliers, or employees for business reasons. These are deductible as ordinary losses, which can fully offset other ordinary income.

Conversely, a non-business bad debt is any debt that did not arise from the taxpayer’s trade or business. This includes personal loans to friends or family members, or loans made for investment activities not part of a trade or business. Non-business bad debts receive less favorable tax treatment; they are deductible only as short-term capital losses and must be entirely worthless to be claimed. These losses are subject to capital loss limitations, meaning they must first offset capital gains, and any remaining loss can only offset up to $3,000 of ordinary income per year, with any excess carried over to future years. The primary motive for creating the debt determines its classification.

Worthlessness Criteria for Tax Purposes

For tax deduction, a debt must be “worthless.” This means there is no reasonable expectation that the debt will be repaid. It is not enough for collection to be merely doubtful or difficult; the debt must be uncollectible. The deduction for a bad debt can only be taken in the tax year the debt becomes worthless.

For most business bad debts, both partial and total worthlessness can lead to a deduction. A partially worthless business debt may be deducted to the extent it is charged off on the taxpayer’s books. Non-business bad debts, however, must be totally worthless to be deductible; no deduction is allowed for partial worthlessness. Indicators of worthlessness include the debtor’s bankruptcy, insolvency, disappearance, or the exhaustion of legal remedies without success. While a formal court judgment is not always necessary, taxpayers must show that reasonable steps were taken to collect the debt or that legal action would likely be futile.

Required Documentation for Deduction

The burden of proof rests on the taxpayer to substantiate a bad debt deduction. Comprehensive documentation demonstrates that a bona fide debt existed and that it became worthless in the year the deduction is claimed. This proof involves more than just a subjective opinion of uncollectibility.

Taxpayers should maintain evidence of the debt’s existence, such as promissory notes, loan agreements, invoices, or written communications establishing a debtor-creditor relationship. Additionally, records detailing efforts made to collect the debt are required. These can include correspondence with the debtor, records from collection agencies, or documentation of legal actions taken. Any facts demonstrating that a reasonable person would conclude the debt is uncollectible, such as bankruptcy filings or evidence of the debtor’s financial distress, should also be kept. For non-business bad debts, a detailed statement attached to the tax return describing the debt, collection efforts, and reasons for worthlessness is required.