Charging Off a Bad Debt: How, When and Why to Do It
For many creditors, the frustrating reality is that it costs money and it takes time to recover the money that is legally owed to them if a borrower stops repaying a loan. The costs of debt recovery can be significant. Foreclosure, for example, can be expensive and take over a year to complete in some states. Therefore, many businesses choose to write off their bad business debts in exchange for the tax benefits provided by the IRS.
What is a Business Bad Debt?
According to the IRS Publication 535 on Business Bad Debts, bad business debts are primarily incurred when a good or service is sold to a consumer and the consumer does not pay for the good. For example, a consumer may default on a car loan or a consumer may fail to pay for the services provided by his or her physician. When a problem like this occurs, the IRS requires businesses to try to collect the amount due for a reasonable period of time. If the business is unsuccessful then the amount owed to the business becomes a business bad debt.
Bad business debts can also be incurred in other situations such as when loans to clients or suppliers are not repaid or when a partnership dissolves and one partner does not repay money that is owed. The other partner may be able to claim a bad business debt or the amount that he paid over his fair pro rata share of the debts.
When Can a Business Charge Off a Bad Debt?
A business can charge off a bad debt, as defined above, if:
- The debt owed to the business was previously included in your gross income. That means that your business must have counted the money owed to it as income when the good or service was provided to the customer. This method of accounting is known as the accrual method. If, instead, your business uses the cash method of accounting where only amounts received by the business are considered income then you cannot charge off a bad debt for income that was never received because you never considered the money owed to you as income.
- You liquidate your business and the accounts receivable become worthless; or
- You sell your business but maintain ownership of the receivables and a receivable is not paid.
There is no need to wait until the time that the debt is due to claim that it is worthless and will not be repaid. Nor do you have to go to Court and get a judgment prior to deciding that a debt is worthless. Instead, you need to have documentation that the debt is worthless and that despite your reasonable efforts to collect on it you will not be able to do so.
The Benefits of Charging Off a Bad Debt
Generally, business who counted the debt as income may take a tax deduction for specific bad debts that become partially or wholly worthless during the tax year. While the deduction does not fully make up for the income lost by not receiving the money owed, it provides some financial benefit to the business. Therefore, businesses should be aware of the circumstances pursuant to which they can claim a bad debt and they should know how to do it when the time comes.