When can an accrual-method business deduct a bad debt?
An accrual-method business may deduct a bona fide receivable previously included in income when it becomes worthless, subject to substantiation.
The tax treatment
An accrual-method business may deduct a bona fide receivable previously included in income when it becomes worthless, subject to substantiation. This is a federal income tax starting point; the contract, ownership, accounting method, and actual use can change the result. State and local treatment should be checked separately.
The decision to make before filing
Document collection efforts and the specific year the debt became uncollectible. The useful planning step is to resolve the classification while the underlying documents are still available, then reconcile it to the books and the prior-year return. If the transaction spans more than one year, track the opening balance and what happened to it afterward.
Illustrative example
A wholesaler reports a customer sale on an accrual return, then the customer liquidates without paying. The company documents the prior income inclusion, collection efforts, and year of worthlessness. A broad reserve against every slow-paying customer is not the same as a specific tax write-off.
Records that support the position
Keep original invoice, income recognition, correspondence, bankruptcy notice, and write-off approval. Tie amounts on the return to bank activity and the agreement. When several assets, people, or uses are involved, write down the allocation method and apply it consistently. A short dated workpaper is easier to defend than a reconstructed explanation years later.
A common reporting error
An accounting allowance for doubtful accounts alone does not establish a tax deduction for a particular debt. Review both sides of the entry: a payment can affect income, basis, liability, or an expense at different times. A correct cash total alone does not establish the correct tax character.
Where to verify the rule
Start with IRS Publication 334: Tax Guide for Small Business. Its examples and cross-references explain the underlying federal rule; check the current version and any later IRS guidance for the year at issue. For a coordinated review of related deductions and limitations, see Business tax planning.
Related Reading
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