What is 'Bad Debt'
Bad debt is debt that is not collectible and therefore worthless to the creditor. Bad debt is usually a product of the debtor going into bankruptcy but may also occur when the creditor's cost of pursuing the debt collection activities is more than the amount of the debt. Once a debt is considered bad, the business may be able to write it off as an expense on its income tax return.
BREAKING DOWN 'Bad Debt'Many businesses make sales on credit, as it generally allows them to increase their sales. Inevitably, most businesses end up offering credit to clients with less than desirable credit, or they face situations in which their clients cannot pay. As a result, companies that make credit sales often estimate the amount of sales they expect to become bad debts, and they record this projection in their allowance for doubtful accounts. Both individual and business debtors with histories of bad debts are likely to have their credit ratings decline, which makes it difficult for these debtors to access any additional forms of credit.
Can Businesses Write Off Bad Debts
The Internal Revenue Service (IRS) allows businesses to write off bad debts on Form 1040, Schedule C, but businesses may only write off debts they have previously reported as income. Bad debts may include loans to clients and suppliers, credit sales to customers, and business loan guarantees, but they typically do not include unpaid rents, salaries or fees.
For example, for tax purposes, the IRS considers a landlord as a small business owner. However, in most cases, if a landlord does not receive rent from a tenant, he cannot write off the missing payment as a bad debt. Conversely, imagine a food distributor that delivers a shipment of food to a restaurant on credit in December. The food distributor uses the accrual method of accounting, so it records the invoice as income on its tax return for that year. However, in January, the restaurant goes out of business and does not pay the invoice. The food distributor can write off the unpaid bill as a bad debt on its tax return for the following year.
Can Individuals Claim Bad Debts on Their Income Tax Returns?
For tax purposes, bad debts are typically associated with businesses. However, in some cases, the IRS allows individuals to write off bad debts as well. If an individual has loaned money to someone else with the expectation of reclaiming it, he can write off the debt as a bad debt. The IRS classifies nonbusiness bad debts as short-term capital losses.