How to Write Off Bad Debt Expense for Your Business

Bad debt expense represents money owed to a business that is deemed uncollectible. These are accounts receivable that a business has determined will not be paid by customers, arising when a customer is unable or unwilling to pay for goods or services provided on credit. Writing off bad debt is an important accounting and financial practice. It ensures that a company’s financial statements accurately reflect its true assets and profitability, providing a clearer picture of financial health. This practice also has implications for tax reporting, potentially allowing for deductions.

Determining a Debt is Uncollectible

Before any accounting or tax actions, a business must establish that a specific debt is uncollectible. This requires demonstrating that reasonable efforts to collect the debt have been exhausted. A debt can be considered uncollectible when the debtor declares bankruptcy, becomes insolvent, or disappears without a trace. Evidence supporting the uncollectibility of a debt is crucial for both financial reporting and tax purposes. This evidence might include:
A copy of the debtor’s bankruptcy filing.
Records of persistent collection attempts, such as detailed logs of phone calls, copies of demand letters, or emails.
Statements from a collection agency indicating their inability to recover the funds.
A legal judgment against the debtor that remains unpaid.
Financial statements from the debtor demonstrating their inability to pay, or a clear admission that they cannot fulfill their obligation.
These documented efforts and outcomes provide the factual basis necessary to classify an account as uncollectible.

Accounting Methods for Bad Debt

Recording bad debt on a company’s financial books can be done using two primary accounting methods: the Direct Write-Off Method and the Allowance Method. Each method has distinct implications for financial reporting and is typically chosen based on the size of the business and the frequency of bad debts. The Direct Write-Off Method is generally simpler and suitable for smaller businesses that experience infrequent or immaterial bad debts.

Under the Direct Write-Off Method, a specific account is removed from the books only when it is definitively determined to be uncollectible. For example, if a $1,000 account receivable from a customer is deemed worthless, the journal entry would involve debiting Bad Debt Expense for $1,000 and crediting Accounts Receivable for $1,000. This method directly impacts the income statement in the period the debt is written off, often violating the matching principle in accrual accounting.

The Allowance Method is preferred by larger businesses using accrual accounting, as it aligns revenues and expenses more accurately. This method involves estimating future uncollectible accounts and creating an allowance for doubtful accounts at the end of each accounting period. This estimation often relies on historical data, such as a percentage of sales or a percentage of accounts receivable based on their age.

When establishing or adjusting the allowance, a company would debit Bad Debt Expense and credit Allowance for Doubtful Accounts, a contra-asset account that reduces the net value of accounts receivable on the balance sheet. For instance, if a company estimates $5,000 in uncollectible accounts, the entry would be a $5,000 debit to Bad Debt Expense and a $5,000 credit to Allowance for Doubtful Accounts. When a specific account of, for example, $1,000 is later determined to be uncollectible, the journal entry involves debiting Allowance for Doubtful Accounts for $1,000 and crediting Accounts Receivable for $1,000. This process ensures that the expense is recognized in the same period as the related revenue.

Tax Treatment of Bad Debt Expense

The tax treatment of bad debt expense is a consideration for businesses and individuals seeking to claim a deduction. The rules for deducting bad debts for businesses are governed by Internal Revenue Code (IRC) Section 166. For tax purposes, a business bad debt must be completely worthless to be deductible; a partial worthlessness may be deducted if the amount can be clearly identified.

Accrual basis taxpayers typically use the specific write-off method for tax purposes, meaning they deduct a bad debt in the year it becomes entirely worthless. The reserve method, commonly used for financial accounting, is generally not permitted for tax purposes. This distinction between accounting and tax methods means that a business might use the allowance method for its financial statements but must track specific worthless debts for its tax return.

A business bad debt arises from the operation of a trade or business. For example, unpaid invoices for goods sold or services rendered on credit are generally considered business bad debts. The debt must have been previously included in gross income for an accrual basis taxpayer, or for a cash basis taxpayer, it must represent a loan made in the course of business that became worthless.

Non-business bad debts, as defined under IRC Section 166, are treated differently for individuals. These debts are not incurred in the ordinary course of a trade or business and are generally treated as short-term capital losses. An example of a non-business bad debt would be a personal loan made to a friend or family member that becomes uncollectible.

The deduction for non-business bad debts is limited to the amount of capital gains plus an additional $3,000 against other income annually. Any unused capital loss can be carried forward to future tax years, subject to the same limitations. This treatment means that while a non-business bad debt is deductible, its immediate tax benefit may be limited compared to a business bad debt.