How to Write Off Bad Debt
Written by Eddy Hood
When a small business takes a loss due to a worthless debt that has been created or acquired by the business, that debt is known as a bad debt. A debt is worthless when it becomes impossible to collect the amount that is owed. Customer credit sales are one of the most common forms of bad business debt that a small business might be faced with. In addition to credit sales, loans to suppliers or clients for business purposes, and business loan guarantees may also qualify as bad debt. Fortunately, it is possible to write off bad debt when you file taxes.
As a business owner, it is naturally never your intent to acquire bad debt. Ideally, you should avoid it as much as possible through proper billing and collection practices. When you are unable to collect payment from a customer or client, the account may become a bad debt write off. As an outsourced accounting firm, we can help improve your client collections by as much as 30 percent. Unfortunately, even with all of the proper steps it may not be possible to avoid bad debt entirely. It is important that you understand how to write off bad debt and whether your business is eligible to do so.
When your business wants to write off bad debt, it must show that efforts were made to collect the money owed. You will also need to estimate how much you are unable to collect and end any further attempts at collection. In addition, the IRS also states that the debt in question must have been previously included in income. For this reason, your accounting method matters as this will also affect whether or not you can deduct bad debt. For example, if your business uses the cash method of accounting, you generally cannot deduct bad debt, because income is not reported until it is received. The other method of accounting is the accrual method. With this method, all of your billing is treated like income, regardless of whether you have collected the money or not. Because the debt has been recorded as income you are able to write it off.
When it comes to how to write off bad debt you have two options: direct write off, which is also known as the specific charge-off method, and the non-accrual experience method. To use the non-accrual experience method your business must qualify by receiving its income from services, such as the services offered by a law firm, for example. In addition, your average annual gross receipts from the three prior years must be $5 million or less. With the more common specific charge off method, debts that become worthless during the tax year may be deducted. The debt may be totally or partially worthless; however, if the debt is only partially worthless only the amount that has been charged off during the year may be deducted.
If the presence of a bad debt write off on your books is a growing problem, turn to Ignite Spot. Our online bookkeeping services can help you by managing your accounts receivable and reducing the amount of bad debt that your company accrues. To start, download our pricing guide to review our fees. For further information on how we can help, contact us today.