Bad Debts

If someone owes you money you cannot collect, you have a bad debt. There are two kinds of bad debts--business bad debts and nonbusiness bad debts.

A business bad debt is generally one that comes from operating your trade or business. You can deduct business bad debts as an expense on your business tax return.

All other bad debts are nonbusiness bad debts and deductible as short-term capital losses on Schedule D (Form 1040). For more information on nonbusiness bad debts, see Publication 550, Investment Income and Expenses.

Business bad debt. A business bad debt is a loss from the worthlessness of a debt that was either of the following.

1. Created or acquired in your business.
2. Closely related to your business when it became partly or totally worthless.

A debt is closely related to your business if your primary motive for incurring the debt is a business reason.

Business bad debts are mainly the result of credit sales to customers. They can also be the result of loans to suppliers, clients, employees, or distributors. Goods and services customers have not paid for are shown in your books as either accounts receivable or notes receivable. If you are unable to collect any part of these accounts or notes receivable, the uncollectible part is a business bad debt.

You can take a bad debt deduction for these accounts and notes receivable only if the amount owed you was included in your gross income either for the year the deduction is claimed or for a prior year.

Accrual method. If you use an accrual method of accounting, you normally report income as you earn it. You can take a bad debt deduction for an uncollectible receivable if you have included the uncollectible amount in income.

Cash method. If you use the cash method of accounting, you normally report income when you receive payment. You cannot take a bad debt deduction for amounts owed to you that you have not received and cannot collect if you never included those amounts in income.

More information. For more information about business bad debts, see chapter 11 in Publication 535.

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