What expense category is Collection Agency Fees?

Unpaid customer invoices are an unfortunate reality for many businesses. When internal efforts to collect a debt fail, hiring a collection agency is often the next step. The fees paid for these services are a necessary cost of doing business, and it's essential for accountants and small business owners to understand that these expenses are deductible.

This guide explains how the IRS views collection agency fees, how to categorize them correctly, the records you need to maintain, and how to automate the tracking of these essential business expenses.

Collection Agency Fees Expense Category

The fees you pay to a collection agency or an attorney to recover a business debt are considered an ordinary and necessary business expense. According to IRS Publication 334, these costs fall under the category of Legal and Professional Fees.

These fees are directly related to the operation of your business and are deductible in the year you pay or incur them, depending on your accounting method.

Important Considerations When Classifying Collection Agency Fees

While the fees themselves are deductible, several important factors must be considered in relation to the underlying debt.

The Link to Proving a Bad Debt

One of the most important functions of using a collection agency is that it helps establish that you have taken reasonable steps to collect the debt, a key IRS requirement. As detailed in IRS Publication 334, before you can claim a business bad debt deduction for an uncollectible invoice, you must be able to show you made substantial efforts to get paid. Documenting your use of a collection agency is excellent proof of this effort.

Deducting the Fee vs. Deducting the Debt

It is crucial to distinguish between deducting the collection fee and deducting the actual unpaid invoice (the bad debt).

• The Collection Fee: This is a standard operating expense and is deductible as a professional service fee in the year it is incurred.
• The Bad Debt: The original unpaid invoice can only be deducted as a bad debt if you previously included the amount in your gross income. This is typically only possible for businesses using the accrual method of accounting. If you use the cash method, you cannot deduct an unpaid invoice as a bad debt because you never recognized the income in the first place.

Timing of the Deduction

You can deduct the collection agency fees in the tax year you pay them (for cash-method taxpayers) or incur them (for accrual-method taxpayers), regardless of whether the debt is ultimately collected.

Examples of Deductible Collection Agency Fees

The fees charged by collection agencies can vary, but all are generally deductible. Common examples include:

• Contingency Fees: The agency takes a percentage of the amount it successfully recovers from the debtor.
• Flat Fees: A fixed cost paid to the agency for their services on a particular account or a batch of accounts.
• Legal Fees: If the collection process requires legal action, fees paid to an attorney for this purpose are also deductible as legal and professional fees.

Tax Implications and Recordkeeping for Collection Fees

How to Report the Deduction

For a sole proprietor filing a Schedule C (Form 1040), collection agency fees should be deducted under Part II, Line 17, Legal and professional services.

What Records to Keep

The IRS requires you to keep supporting documents for all your business expenses. You cannot deduct estimates. For collection agency fees, your records must include:

• Invoices from the collection agency or law firm detailing the services provided.
• Proof of payment, such as canceled checks or credit card statements.
• Contracts or agreements with the collection agency.
• Records identifying the specific debt the agency was hired to collect, linking the fee to a legitimate business purpose.

How Fyle Can Automate Tracking of Collection Fees

Manually tracking invoices and payments to third-party agencies adds another layer of administrative work to the already difficult process of collections. Fyle helps automate this tracking for perfect, audit-ready records.

• Centralized Invoices: Agency invoices can be emailed directly to a dedicated Fyle address, where the data is automatically captured and organized.
• Link Expenses to Clients: The collection fee can be coded to the specific client or project to which the original unpaid invoice belongs, creating a clear link for accounting.
• Create a Clear Audit Trail: Fyle consolidates the agency's invoices, proof of payment, and related notes into a single digital expense record for easy access.
• Automate Your Accounting: With direct integrations to QuickBooks, Xero, NetSuite, and Sage Intacct, the categorized collection fee is synced directly to your Legal and Professional Fees account in the general ledger.