Bad Debt vs. Net Write-Off

A business that extends credit to its customers may find that some of its invoices are paid late, or in some cases not at all. Collecting bad debt is a critical part of maintaining your cash flow and keeping a healthy balance sheet. At some point, however, a debt becomes so far delayed that it has to be written off.

Documenting Bad Debt

As the name suggests, a bad debt is one that a business can’t collect. This often results from credit sales to customers for goods that have been received but not yet paid for, and have been recorded in your company’s accounts receivables. The Internal Revenue Service expects businesses to show some effort to collect such debts before writing off the amounts. For example, if the debt is the result in a loan to a supplier, it helps to have the debt recorded in a document with the expected returns indicated, and to retain copies of letters or e-mails demanding the funds be repaid.

Deducting Debt

The IRS allows bad debt to be written off and deducted from your tax return under specific circumstances. Bad debts for businesses -- such as loans to clients and suppliers, credit sales to customers and business loan guarantees -- can be deducted both in full or in part from gross income. Any other debt is considered a non-business debt and must be totally worthless to be deductible. This would be recorded as a short-term capital loss. For a debt to be considered worthless, the business has to show that there’s no reasonable expectation that it will be repaid. While you must have taken reasonable steps to collect it, you don’t have to go to court to collect it if you can prove that obtaining a judgment would still leave the debt uncollectable.

When to Give Up

In some cases, a debt is written off according to a specific schedule -- such as if it has gone uncollected after six months. In other cases, debts are written off only when the situation makes it obvious that repayment won’t be made. For example, many business bad debts occur as the result of a client’s bankruptcy. When that happens, a business may assess the situation and determine that its position among the creditors is so low that there is no possibility it will receive any money as part of an eventual settlement.

Determining Debt Value

Bad debts can only be written off at the fair market value. For example, a business that acquires an accounts receivable at a discount and fails to collect on the note can deduct only what it paid. If a debt is declared worthless but then recovered later – like if a business unexpectedly gets a payment from a client years after the invoice was sent – the amount is claimed as income on that year’s tax return.