Can You Write Off Bad Debt?

While running a business, you need to closely watch your assets and liabilities. A bad debt is nothing but money which is owed to you by your customers, which you can't collect, despite your efforts. Bad debt is written off so that the business is protected and they don't need to pay taxes on money they haven't received. The amount is written off as a loss for the business and is said to be an expense for the company. It's called bad debt expense as these debt can't be collected even after taking all efforts to recover the amount have failed.

This kind of situation usually occurs when your customer has declared bankruptcy or the total cost of recovering the amount exceeds the amount in debt. In the following paragraphs we give you the steps on how to write off bad debts.

How to Write Off Bad Debt

The first step while thinking of writing off bad debt is determining whether you are eligible to write it off. A bad debt must be an outcome of losing income which has been previously reported or money you may have loaned to someone. You can't include income lost as bad debt if you have not filed the likely source of funds while filing your income tax returns, i.e., if you owe your customers money, you should file that in your income tax return. Later on if you can't recover that money, you can file for bad debt. But if you have not shown the likely amount you are to receive, while filing your tax returns, you can't claim the debts later on.

The second step while you think of how to write off bad amounts is to determine whether it's a personal bad debt or a business bad debt expense. Personal debt means money you may have loaned to a relative or friend, who at a later date failed to repay them. On the other hand, business debt is created as a part of a business. For example, if a client fails to repay you the amount owed, it's called business debt.

Bad debts in a business are considered expenses and while filing your business tax returns you should show it so that it can be deducted and declared worthless. Debts of a business are deducted in full. If it's a corporation, they should be filed in Form 1120, while if it's a sole proprietorship, you should fill up the Schedule C of the filing form. A net operating loss may be created by a bad debt and you can opt to either carry it forward or backwards. If you have loaned an amount to a relative and over time, it becomes a liability, it's said to be a short-term capital loss. In such a case, you should claim it in Schedule D of Form 1040. Once you fill up the form, it would first be matched with the gain in capital in Schedule D and the remaining loss which may be there would then be calculated. The deductible capital loss has a limit of US$3,000 a year and if you are married filing separately the amount is US$1500.

It's necessary for you to remember here that personal bad debts need to be documented carefully. It is especially important if the money was loaned out to a relative. When the IRS audits your income, they would need a copy of promissory note. You may also be required to show any other documents which would prove that the money which you gave out was really a loan and not a gift. You may also need to show the demand letter and other documents of correspondence which would show that you have made efforts to recover the amount. If there is no effort from your side to recover personal debt, you can't write off bad debt while filing your tax returns.

The year in which it becomes worthless, you must file to write off such debt on your tax returns. You can't file for writing off bad debts in later years. However, if a debt becomes partially worthless in a particular year then it's possible to write off that amount. Thus, it is possible to write off bad debts, but you need to make sure that you follow the rules and regulations well in time so that you can claim the benefits of bad debts being written off.