Sometimes, no matter how hard you try to collect a debt, it eventually becomes clear the debtor is not going to pay. When this happens, you generally have the ability to write off the bad debt. Here’s what you need to know if you have uncollected debt on your books.
In order to write off an uncollectable receivable, it must qualify as a bad debt in the eyes of the IRS. In order to do that, you have to be able to prove four things about the debt. First, you must show that it is bona fide. That means the debt arose from a valid obligation of the customer to pay you. If you provided the customer with goods or services in return for expected payment, or had a contract with them, it qualifies the debt as bona fide.
Next, you have to show you have a basis in the debt, which means you have already counted the debt in your business’ gross income. If you use the cash method , where you don’t count income until you receive payment, the debt won’t qualify as bad because it was never on your books as income. But if you use the accrual method, where you count the income when an order is placed or when you deliver the product or service, you do qualify. For example, if you sell a customer a product in January and wait until he pays you in March to add it to your books, you don’t have a basis in the debt. But if you count the income on your books in January, you do.
You will then need to show the IRS the debt is related to your business. Simply showing that a customer or other business ordered products or services from you and you expected payment for it should satisfy this requirement.
Finally, you will have to prove the debt is worthless. To do this, you’ll need to show you took reasonable steps to collect the debt and have no chance of being repaid. You can do this by documenting your attempts to collect, showing the customer filed bankruptcy, or whatever else leads you to believe that the debt is uncollectable. If you collected a portion of the debt, you can claim it to be partially worthless and only write off the portion you were unable to collect as long as the full debt was included on your books.
Most business owners will have to use the direct write-off method , also called the specific charge-off method, to take the debt off the books. If the debt is partially worthless, deduct the portion of the debt that you wrote off during the current year. You also have the option of waiting until it becomes completely worthless and deducting it then.
If the debt is totally worthless, you should deduct the entire amount in the year it became uncollectable. If you deducted a portion of it as a partially worthless debt in a prior year, then only deduct the remaining balance.
You should report bad debts as ordinary losses on Form 1040 (PDF) in conjunction with Schedule C (PDF), Schedule A (PDF), or if you’re in the farming business, Schedule F (PDF).
If you had bad debts in prior years, and didn’t take the write off, the IRS allows you some time to file for the credit. If the debt is partially worthless, you have three years from the date you filed the original tax return, or two years from the date you paid the tax. If it was totally worthless, the IRS gives you seven years from the date of the original return and two years from the date you paid the tax.
If you are a sole proprietor or farmer, you should use Form 1040X (PDF) to file a claim. If you own a partnership, use Form 1065 (PDF). If your business is structured as an S-Corporation, you’ll need to use Form 1120S (PDF), and Form 1120X (PDF) if your business is a C corporation.
Writing off bad debt amounts to more than just the amount of the debt. For instance, if you write off $5,000 in debt this year and operate on a 10 percent profit margin, you will have to sell $50,000 to make up for the bad debt. You can use this free online write-offs monitor to determine how much your bad debt is costing you.
Since bad debt hurts your business’ bottom line so much, you should take every precaution to avoid it. Here are some ideas:
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