Bad debt is money owed that is unlikely to be collected. Learn the bookkeeping entry, federal tax rules, records, and California considerations.
Bad debt is a valid amount owed to a business or individual that has become partly or completely uncollectible. Common examples include an unpaid customer invoice or a bona fide loan the borrower cannot repay.
"The customer has not paid yet" is not enough by itself. The creditor should determine that a real debt exists, evaluate the facts showing it is unlikely to be collected, document reasonable collection efforts, and apply the correct bookkeeping and tax rules.
Under the direct write-off method, a business records bad-debt expense when a specific receivable is determined to be uncollectible and credits accounts receivable. Under an allowance method, the business estimates expected credit losses earlier; the later write-off reduces both the allowance and the customer receivable, generally without recording a second expense at that time.
The allowance approach better matches expected credit losses with the related sales for financial reporting. Some small businesses use direct write-off bookkeeping for simplicity. The financial-reporting method and federal tax method are not automatically the same.
Coastal Design LLC billed a customer $6,000 and, because it uses accrual accounting, recorded revenue and accounts receivable. The customer later closed, stopped responding, and had no known assets. After retaining the contract, invoice, correspondence, collection notes, and closure evidence, Coastal concludes that the balance is worthless.
| Direct write-off entry | Amount |
|---|---|
| Debit bad-debt expense | $6,000 |
| Credit accounts receivable | $6,000 |
Total assets and current assets fall by $6,000, and book profit falls by $6,000. If Coastal had already established an allowance, the write-off would debit the allowance and credit accounts receivable. The earlier estimate, rather than the final removal, generally carried the book expense.
Federal tax law generally requires a bona fide debt arising from a debtor-creditor relationship and a valid obligation to repay. To claim a bad-debt deduction, the taxpayer generally must previously have included the amount in income or actually loaned cash.
A business bad debt is generally one created or acquired in a trade or business or closely related to the business when it becomes partly or totally worthless. Business bad debts are generally treated as ordinary losses. Nonbusiness bad debt generally must be totally worthless and is treated as a short-term capital loss.
A payment labeled "loan" is not necessarily debt. Evidence may include a note, repayment terms, interest, collateral, payment history, collection activity, and the borrower's ability and intent to repay when funds were advanced. Money transferred with no genuine expectation of repayment may be a gift or capital contribution rather than deductible debt.
Stock that becomes worthless is generally handled under worthless-security rules, not as bad debt. A disputed invoice may require correcting revenue or issuing a credit memo rather than declaring a valid receivable worthless.
No single event is required in every case. Relevant facts can include bankruptcy, insolvency, closure, unsuccessful collection efforts, lack of reachable assets, expiration of enforceable remedies, or a settlement establishing the unrecoverable amount. A taxpayer does not always have to sue when a judgment would be uncollectible, but should be able to explain the decision.
Worthlessness must be placed in the correct year. Waiting indefinitely can misstate financial statements and jeopardize tax treatment; writing off a balance merely because it is old can be premature.
California business and individual returns generally begin with federal tax concepts but may require state adjustments depending on the taxpayer and item. Preserve the federal workpaper, book-to-tax reconciliation, debt evidence, and California return support. Do not assume a book allowance or write-off automatically equals the California deduction.
Retain contracts, signed notes, invoices, proof of funding, income records, payment history, correspondence, collection logs, credit reports, bankruptcy or closure information, legal advice, settlements, board or owner approval, journal entries, and tax workpapers. Record why the debt was valid, why it became worthless, and when that conclusion was reached.
Heath Income Tax can help reconcile receivables, document write-offs, and evaluate the book and tax treatment of potentially uncollectible balances.
Is every unpaid invoice bad debt?
No. It may still be collectible, disputed, erroneous, refundable, or subject to a credit. Determine what happened before posting a write-off.
Can a cash-method business deduct unpaid invoices?
Generally not when the related fees were never included in taxable income. A separate cash loan can have basis and requires its own analysis.
What happens if money is later collected?
Reverse or record the bookkeeping recovery appropriately. A prior tax deduction may also produce taxable recovery income, subject to the tax-benefit rules.
The definitions and examples on this page are for informational purposes only and do not constitute tax advice. Tax laws change frequently and individual circumstances vary. Consult a qualified tax professional before making decisions based on this content.
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