Business Bad Debt Deduction: Writing Off Unpaid Invoices (IRC 166)

Bad debt deduction rules:

Cash basis vs. accrual basis:

Accounting Method	Invoice Sent	Payment Received	Bad Debt Deduction?
Cash basis	Not yet income	Income when received	No (nothing to deduct)
Accrual basis	Income when sent	Already counted	Yes (reverse the income)

Most small businesses use cash basis. If a customer doesn’t pay a $5,000 invoice, the cash-basis business never reported the $5,000 as income, so there’s nothing to deduct. The loss is real (the work was performed, the materials were used), but the tax deduction doesn’t exist because the income was never recognized.

When a cash-basis business CAN deduct a bad debt:

• Loans to customers or vendors (the loan itself was a payment, creating a basis)
• Deposits paid that are not returned (the payment created basis)
• Credit sales where the income was previously reported (rare for cash basis)
• Goods sold on credit where the cost of goods is deductible (the COGS deduction already offsets, but inventory loss is deductible)

Requirements for the deduction (IRC 166, Reg. 1.166-1):

1. Bona fide debt: a genuine debtor-creditor relationship (not a gift or capital contribution)
2. Previously included in income: the amount was reported as revenue (accrual basis) or as a paid amount (loan)
3. Worthlessness: the debt is wholly or partially uncollectible
4. Reasonable collection effort: the business attempted to collect (demand letters, calls, collection agency)
5. Documentation: written records of the debt, collection efforts, and determination of worthlessness

Wholly worthless vs. partially worthless:

• Wholly worthless: the entire debt is uncollectible (customer bankrupt, disappeared, defunct business)
• Partially worthless: some portion may be recoverable (customer negotiating partial payment, in bankruptcy with expected distribution)
• Wholly worthless: deduct the full amount in the year of worthlessness
• Partially worthless: deduct only the amount charged off on the books (must make an actual charge-off entry)

Business vs. nonbusiness bad debt:

Type	Treatment	Limitation
Business bad debt	Ordinary loss	Fully deductible against ordinary income
Nonbusiness bad debt	Short-term capital loss	Limited to $3,000/year (excess carries forward)

A business bad debt must arise from the operation of the taxpayer’s trade or business. A loan to a friend that goes bad is a nonbusiness bad debt (treated as a short-term capital loss, limited to $3,000/year offset against ordinary income).