What expense category is Bad Debts?

When a customer fails to pay an invoice for goods or services, that uncollectible amount becomes a bad debt. For businesses that extend credit, bad debts are an unfortunate but common occurrence. The IRS allows businesses to deduct these losses, provided they follow specific rules.

The most important rule depends on your accounting method. Generally, only businesses using the accrual method of accounting can deduct bad debts for unpaid services or sales. This guide explains what constitutes a business bad debt, the requirements for deducting it, and how to track related information for tax compliance.

The Bad Debts Expense Category

A business bad debt is a loss resulting from a debt that was created or acquired in the course of your trade or business. These are reported on a specific line on your tax return. For a sole proprietor filing a Schedule C (Form 1040), this is Part II, Line 9, Bad debts.

This is a direct deduction from your business income. However, how you claim it is strictly defined by the IRS.

Important Considerations When Classifying Bad Debts

Before deducting a bad debt, you must ensure it meets the IRS criteria for both its business connection and its worthlessness.

Business vs. Nonbusiness Bad Debts

IRS Publication 334 emphasizes that only business bad debts can be deducted on your business tax return. A business bad debt is one that comes from operating your trade or business, such as credit sales to customers or loans to suppliers. A non-business bad debt (such as a personal loan to a friend) is treated differently as a short-term capital loss.

The Accrual Method Requirement

This is the most critical rule. You can only claim a bad debt deduction if the amount you were owed was previously included in your gross income.

• Accrual Method Users: You generally report income when you earn it (e.g., when you send an invoice). Because you've already reported the income, you can deduct the bad debt when it becomes uncollectible.
• Cash Method Users: You report income only when you receive payment. Since you never received payment for the unpaid invoice, it was not included in your income. Therefore, you cannot take a bad debt deduction for it.

Proving a Debt is Worthless

You can only deduct a bad debt in the year it becomes worthless. According to Publication 334, you must be able to show that you have taken reasonable steps to collect the debt. This doesn't mean you have to go to court, but you must be able to prove your collection efforts. The bankruptcy of a debtor is generally good evidence that at least part of a debt is worthless.

The Specific Charge-Off Method

The only permissible method for deducting business bad debts is the specific charge-off method. This means you can only deduct specific, identifiable debts that have become uncollectible. You cannot deduct a reserve or estimate for bad debts you expect to have in the future.

Tax Implications and Recordkeeping

To deduct a bad debt, you must report it correctly and maintain thorough documentation.

How to Report the Deduction

For a sole proprietor, the amount of uncollectible debt is reported on Schedule C (Form 1040), Line 9, Bad Debts.

What Records to Keep

You must keep records to prove that the debt is genuine and that it has become worthless. Your documentation should include:

• The original invoice or contract creating the debt.
• Records showing that you properly included the amount in your business income (for accrual-method taxpayers).
• All correspondence and records of your attempts to collect the debt (e.g., emails, letters, call logs).
• Any notices of bankruptcy or documentation from a collection agency.

Recovery of a Bad Debt

If you deduct a bad debt and later recover all or part of it, you must include the recovered amount in your income in the year you receive it.

How Fyle Can Automate Tracking for Bad Debt Documentation

While Fyle doesn't manage your accounts receivable, it is an essential tool for tracking the expenses related to collection efforts and centralizing the documents needed to prove a debt is worthless.

• Track Collection Costs: Capture and categorize all fees paid to collection agencies or attorneys as a Legal & Professional Fee.
• Centralize Key Documents: Attach all relevant documents—the original invoice, collection letters, and final notices—to a single expense record in Fyle.
• Create a Clear Audit Trail: Fyle provides a time-stamped, unalterable record of your collection efforts and associated costs.
• Automate Your Accounting: Sync collection-related expenses directly to the correct GL account in QuickBooks, Xero, NetSuite, or Sage Intacct.