Consultant’s Corner: Business Bad Debts

Question: “Some of my clients have not paid me. Can I deduct my business bad debts?”

Bad debt deductions depend upon the accounting method you use (cash or accrual) and other factors; however, a business can generally only deduct a business bad debt for unpaid invoices to the extent that the amounts invoiced were previously recognized or included in income.

For example, under the cash method of accounting, a business recognizes revenue when it receives cash or a cash equivalent payment such as a payment by check, credit card, services in-kind or transfer of other property. Thus, if you use the cash method, amounts that you invoice that go unpaid are not written off as bad debts because they were never recorded in revenue.

In contrast, under the accrual method of accounting, a business typically recognizes revenue for products sold when they are shipped or delivered and services rendered when the services are performed, even if payment for those products or services will not be received until a later date. Under the accrual method, businesses typically set aside a certain portion of their Accounts Receivable as uncollectible accounts and then write off those uncollectible accounts as bad debt expenses, but there is not a specific timeframe for writing off uncollectible accounts.

If you use the accrual method, your accountant can help you determine how much of your accounts receivable (A/R’s) you should set aside as uncollectible accounts and establish timetables for writing off those accounts as bad debt expenses. Your accountant can also help you set up the proper account structure for reflecting your uncollectible accounts in your accounting books. For discussion with your accountant, you can review IRS information and guidelines on bad debt expenses, including this important section in Publication 535 on when a debt becomes worthless:

“A debt becomes worthless when there is no longer any chance the amount owed will be paid. This may occur when the debt is due or prior to that date.

To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.”

TO learn more about IRS information on accounting methods, read IRS Publication 538.

Whether you need to report your write-off or cancellation of any customer’s or client’s debts to those customers or clients and the IRS using Form 1099-C will depend on your business accounting method. Again, if you use the cash method of accounting for your business, you cannot claim a bad debt deduction, so you typically would not report your write-off or cancellation of any customer or client debts on Form 1099-C. If you use the accrual method of accounting for your business, you may need to report your cancelled customer or client debts to the IRS using Form 1099-C and provide copies of these forms to your affected customers or clients. Forms 1099-C should be prepared for the calendar year in which the debts were written-off or cancelled in accordance with IRS rules, regardless of whether the recipient or IRS deadline for submitting these forms has passed. You can find IRS Form 1099-C and filing instructions here.

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