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.
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.