As great as it would be if all customers were honest customers and paid what they owe every time, every once in awhile, you’re bound to run into a bad egg or two. Writing off bad business debts may require changing your business accounting up quite a bit, but in the end, you will likely find it highly useful for balancing income and loss.
What Qualifies as Bad Debt?
Most bad debt comes from allowing customers to use credit when they receive a service or product, then payment never happens. Another common source would be offering loans and never acquiring repayment. Despite thegenuine loss of money from unpaying customers, there are still specific guidelines for the IRS to approve your bad debt claims.
To count as bad debt, there must be proof that the customer truly owed you, you already included the amount as income in your books, the debt is related to your business transactions, and it is partly or completely worthless. In other words, you reasonably pursued the debt collection, and it’s clear you won’t be seeing that money ever.
How to Write Off Bad Debt
While bad debts can be removed from business income at the end of the year, they must be marked as income upon initial billing to qualify. This process is known as the accrual accounting method. Under the better-known cash accounting method, you record a sale upon collecting payment. The problem with this is that if it’s never paid, there’s no prior record of it as income. You basically lose the time and money. With accrual accounting, all sales are recorded when the customer is billed, so you know exactly how much you “made” for the year versus what you actually did. At the end of the year, you manually subtract these loss amounts from your sales records prior to preparing a tax return and enter the amount on a Schedule C form.
You do have to wait until the end of the year to do this—in case someone magically appears with the money owed to settle their account. Prepare an accounts receivable report listing all owed money, with the amount and the length of time it has gone unpaid. There’s a space on Schedule C forms to deduct your bad debt total for the year.
Is it Worth it to Your Business?
Generally, yes, it is. Since it’s difficult to guess what amount you’ll be shorted for the year, one year could be fine, and the next it happens so frequently, your bottom line goes into the negative. It also messes with your estimated cash flow, because you weren’t counting on the loss, so your estimated income is off in comparison to your expenses.
Despite the distinct extra time and effort it takes to use an accrual accounting system and enter lost debts at the end of the year with necessary proof, it is generally still absolutely worth it. It can deter your business from sinking into the negative, going under, or having disparities in cash flow that influence major business decisions.
