Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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Business bad debt refers to any debt created or acquired in a trade or business (or closely related to a trade or business) that becomes partially or completely worthless and can not be collected.
Business bad debt is the result of a customer, another business, or an individual who cannot or refuses to pay their debt obligation to your business for goods and services received or rents owed.
Debt may be considered closely related to a business if it was incurred for legitimate business purposes such as lending money to a business owner so the business can pay a supplier or meet payroll cash requirements.
Business Bad Debt as A Result of Credit Sales
More often than not, business bad debts are the result of sales on credit extended to customers that are never fully paid.
When using the accrual basis of accounting, goods that are delivered (and likewise services that are performed) are recorded on the company’s books at the time of sale as either accounts receivable or as a note receivable.
If the goods, services, or rental income is not received from the company’s customers or tenants and the income was recorded previously on the Profit and Loss Statement under the accrual basis of accounting, then the ability to write off the debt as an expense for business bad debt may be present.
On the other hand, if the company records its revenue and expenses on the cash basis of accounting and the customer does not pay for the goods, services, or rents, then a deduction for business bad debt is not permitted. It is not permitted because the income from the sale transaction did not occur in the first place.
Nevertheless, any expenses related to the sale associated with the business bad debt are deductible under both the accrual basis and cash basis of accounting. Such expenses would include raw materials, inventory, utilities, rent, wages, salaries, payroll taxes, among others.
Debt Worthlessness
A debt becomes worthless when you are unable to collect the debt after a reasonable amount of time has passed.
To write off a business bad debt as an expense on your accrual basis accounting records and/or tax returns, you will need to demonstrate that you took reasonable steps to collect the debt and were unsuccessful. If the debtor claims bankruptcy, this process is easier as written evidence of the uncollectible status of the debt will be available.
Financial Statement Consequences of Business Bad Debt Write Off
Despite the fact that the presence and need to write off a bad debt for a given business may be an extraordinary occurrence, bad debt expense is considered part of normal operating expenses for any business. Hence, when bad debts are written off as uncollectible by a business, it’s recorded as an ordinary operating expense on the Profit and Loss Statement.
Tax Consequences of Business Bad Debt Write Off
Business bad debt is completely deductible, even if the debt has some remaining value. However, the accounts receivable and notes receivable are deductible only for their fair market value at the time they were received. In the event you purchased an account or note receivable for less than its face value, you may only deduct the amount that you paid for it.
Lastly, a business bad debt is written off against ordinary income on an individual’s personal income tax return which differs from a non-business bad debt which is written off as a short-term capital loss.
Good morning,
I am currently interviewing brokerage companies to represent me in the sale of my two companies. I am wondering when to involve an attorney to represent me during the sale and if I should seek out my own attorney outside of the brokers umbrella of attorney’s or that he is associated with?
Thank you.
Sheila:
The time to consult with your attorney (AND tax advisor) is BEFORE you try to sell your business. Do you know the best ways to structure your business for tax savings? Is this in line with what a Buyer might request? What about legal pitfalls? Do you know what they are before you get put into a corner by an interested seller?
By all means get your own advice! Don’t rely on a broker because his interests are different than yours. The broker’s attorney is looking out for the broker, not YOU! Without your own attorney, how do you know the broker’s deal with you is fair? Don’t rely on the internet or your friends for something as important as selling your “baby”.
Mr. Klein,
Thank you for the confirmation, it solidifies what I was thinking. Now I best get busy locating a reputable attorney.
Respectfully,
Sheila Kern
My client had a business and the guy that bought it, quit paying. They spent $70,000 in legal fees to try and collect the remaining funds he owed. Can we deduct the $70k as a business bad debt? Not really sure where we could put it, but it was to get their business back.
Dear Karen
Legal fees that are related to your business are deductible expenses. However, legal fees associated with personal expenses cannot be included in your itemized expenses. Since the fees may be related to a business’s sale, you may want to consult with a CPA or tax attorney.
Sincerely,
Chris
The information provided is not designed or intended as legal or financial advice. It is for the educational or sharing of informational purposes only. It is not a substitute for consulting with your legal or financial advisors to obtain their professional consultation
I was a shareholder in a sub s corporation with several other executives in the company. The company would pay dividends to the shareholders during the year. If at the end of the year during audit additional expenses were incurred that werent anticipated during the year and a major extra expense was incurred it could reduce the net and cause the company to have over distributed dividends. The difference would then be allocated to all shareholders in the form of a note to the company with interest and a specified pay back timeframe. The question is, if this company goes out of business and those notes arent paid back can the company count them as uncollectable bad debt if they arent repaid? The company is a sub-s.
Hi CF,
When the company writes off a note receivable on the S Corporation’s books from a shareholder, it is not recorded as a Bad Debt Expense because it did not have anything to do with the operations of the business.
Instead, it had to do with the capital structure of the business (recorded on the balance sheet).
The notes receivable may be considered uncollectable, however the business could not charge the balance to bad debts expense.
Hope this helps…