Can You Write Off Bad Debt?

Madhurjya Bhattacharyya Jan 25, 2019
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While doing business, many a time you have to give credit to your customers and sometimes they may not be able to pay you back. In such a case, you fall in bad debt which can be written off. But how?
In business, you need to closely watch your assets and liabilities. A bad debt is money owed to you by your customers, which you can't collect despite efforts. Bad debt is written off so the business is protected and you don't need to pay taxes on money you haven't received. It is written off as a loss for business and said to be an expense for company.
It's called bad debt expense as it can't be collected even after all efforts to recover the amount. This situation usually occurs when your customer has declared bankruptcy or the total cost of recovering the amount exceeds the amount in debt. Here are few steps to guide you in clearing off the bad debt.

Determining the Eligibility

The first step while thinking of writing off bad debt is determining whether you are eligible to write it off. It must be an outcome of losing income, which has been previously reported, or money you may have loaned to someone.
You can't include income lost as bad debt, if you have not filed the source of funds while filing income tax returns, i.e., if you owe your customers money, you should file that in your income tax return. Later, if you can't recover the money, you can file for bad debt. But if you have not shown the amount you are to receive, you can't claim the debts later.

Personal or Business

The second step is to determine whether it's a personal or a business bad debt expense. Personal debt means money you may have loaned to a relative or to a friend, who at a later date failed to repay. On the other hand, business debt is created as a part of a business. For example, if a client fails to repay you the amount owed, it's called business debt.
Bad debts in a business are considered as expenses and while filing your business tax returns, you should show them so that they can be deducted and declared worthless. Debts of a business are deducted in full. If it's a corporation, they should be filed in Form 1120, while if it's a sole proprietorship, you should fill up Schedule C of the filing form.
A net operating loss may be created by a bad debt and you can opt to either carry it forward or backwards. If you have loaned an amount to a relative and over a period of time it becomes a liability, it's said to be a short-term capital loss. In such a case, you should claim it in Schedule D of Form 1040.
Once you fill up the form, it would first be matched with the gain in capital in Schedule D and the remaining loss which may be there would then be calculated. The deductible capital loss has a limit of US$3,000 a year and if you are married and filing separately, the amount is US$1500.

Documentation in Personal Bad Debts

It's necessary to remember that personal bad debts need to be documented carefully. It is important if the money was loaned out to a relative. When the IRS audits your income, they would need a copy of promissory note. You may also be required to show any other documents which would prove that the money which you gave out was really a loan and not a gift.
You may also need to show the demand letter and other documents of correspondence which would show that you have made efforts to recover the amount. If there is no effort from your side to recover personal debt, you can't write it off while filing tax returns.
The year in which it becomes worthless, you must file to write off such debt on your tax returns. You can't file for writing it off in later years. If a debt becomes partially worthless in a given year, it's possible to write off the amount. It is possible to write off bad debts, but you need to follow the rules well in time so that you can claim benefits.
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