How to Write Off a Receivable: Accounting and Tax Steps

Accounts receivable represent money owed to a business for goods or services delivered on credit. Some accounts receivable inevitably become uncollectible, known as “bad debt.” Writing off uncollectible receivables is a necessary accounting procedure to accurately reflect a business’s assets. This process also impacts tax obligations.

Determining an Account is Uncollectible

Before a receivable can be formally written off, a business must establish that the debt is uncollectible. Objective evidence of worthlessness is required. A debt is uncollectible if the debtor has filed for bankruptcy, become insolvent, or passed away, making repayment impossible.

A debt may be deemed uncollectible after documented collection efforts have failed to yield payment. Expiration of the legal statute of limitations for debt collection also provides objective evidence that a debt is no longer recoverable.

Businesses should maintain consistent criteria for uncollectible accounts. Documenting collection attempts, communications with the debtor, and formal notices (e.g., bankruptcy filings, insolvency declarations) is important. These records prove the debt’s worthlessness for write-off.

Recording the Write-Off in Your Books

Once a receivable is determined to be uncollectible, it is removed from accounting records via write-off. The method used depends on the business’s accounting practices, whether it uses the direct write-off method or the allowance method for bad debts. Each method involves distinct journal entries.

The direct write-off method is used for specific uncollectible accounts. The account is written off directly when deemed worthless. The journal entry debits Bad Debt Expense and credits Accounts Receivable. For example, a $500 uncollectible receivable debits Bad Debt Expense and credits Accounts Receivable for $500.

Larger businesses, or those on the accrual basis, use the allowance method. It estimates uncollectible accounts before specific debts are identified. The initial entry debits Bad Debt Expense and credits a contra-asset account called Allowance for Doubtful Accounts.

When a specific account is later identified as uncollectible under the allowance method, it is written off against the allowance. This write-off does not affect Bad Debt Expense. The journal entry involves debiting Allowance for Doubtful Accounts and crediting Accounts Receivable.

Tax Implications of Writing Off Bad Debt

Writing off bad debt has tax implications, as businesses can deduct them. Internal Revenue Code Section 166 permits a deduction for business bad debts that become wholly worthless. To qualify as a business bad debt, it must arise from the taxpayer’s trade or business.

Business bad debts are fully deductible against ordinary income, unlike non-business bad debts. Non-business bad debts typically arise from personal loans or those not directly related to the taxpayer’s trade or business. To claim a deduction, the business must demonstrate that the debt is “wholly worthless,” meaning no reasonable prospect of recovery.

The tax treatment also depends on the taxpayer’s accounting method. Businesses using the accrual method can deduct bad debts when they become worthless. In contrast, cash-basis taxpayers cannot deduct bad debts for uncollected income because they never recognized that income. They can only deduct out-of-pocket expenses for the uncollected debt.

Businesses must maintain documentation to substantiate the worthlessness of a debt for tax purposes. This includes evidence of collection attempts, debtor communications, and legal or insolvency proceedings. Without adequate proof, the Internal Revenue Service may disallow the deduction, requiring additional taxes and penalties.

What Happens After a Write-Off

A written-off receivable might still be collected, a scenario known as a bad debt recovery. Businesses need procedures to account for these recoveries, as they affect financial statements and tax obligations. The accounting treatment for a recovery depends on the method originally used for the write-off.

If the direct write-off method was used, the recovery is recorded by reversing the original write-off entry and recording the cash receipt. This involves debiting Accounts Receivable, crediting Bad Debt Expense for the amount recovered, then debiting Cash and crediting Accounts Receivable upon payment.

When the allowance method was used, recovery involves two steps. First, the specific account is reinstated by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. Then, the cash receipt is recorded by debiting Cash and crediting Accounts Receivable.

From a tax perspective, recovery of a written-off bad debt may be subject to the “tax benefit rule.” If a bad debt deduction provided a tax benefit, the recovery must be included in taxable income. Businesses only include the amount of the recovery that provided a tax benefit.