Business Bad Debt Deduction: When and How to Write Off Uncollectible Debts
Writing off a bad debt sounds simple, but the IRS has specific requirements that trip up many business owners. The fundamental rule: you can only deduct a debt that was previously included in income. For cash-basis businesses (the majority of small businesses), this creates a critical limitation, because accounts receivable are never included in income until collected. A $10,000 invoice that a customer never pays was never counted as revenue in the first place, so there’s nothing to write off. The bad debt deduction under IRC 166 is most useful for accrual-basis businesses, loans that have gone bad, and amounts previously included in income that become uncollectible.
Business bad debt deduction rules:
Who can deduct:
- Accrual-basis businesses: the full amount of uncollectible accounts receivable (because the revenue was already recognized when earned, regardless of collection)
- Cash-basis businesses: only debts that were previously included in income (this is rare for A/R, since cash-basis businesses don’t recognize revenue until collected)
- Any business: loans to customers, employees, or suppliers that become uncollectible (if the loan had a business purpose)
Requirements:
- There must be a bona fide debt (a genuine debtor-creditor relationship with a legal obligation to repay)
- The debt must be connected to your trade or business
- The debt must be wholly or partially worthless
- You must have a basis in the debt (you must have previously included the amount in income or made a cash outlay)
Wholly worthless vs. partially worthless:
- Wholly worthless: the entire debt is uncollectible. Deduct the full amount in the year it becomes worthless. No specific event is required, but you must show reasonable collection efforts failed.
- Partially worthless: part of the debt is uncollectible. Deduct only the worthless portion. Must charge off the amount on the books.
- Non-business bad debts: treated as short-term capital losses (not ordinary losses). Limited to $3,000/year against ordinary income. Only deductible when WHOLLY worthless (no partial deduction).
What constitutes “worthless”:
- Customer files bankruptcy
- Customer disappears (no forwarding address, phone disconnected)
- Customer repeatedly refuses to pay despite demands
- Statute of limitations on collection has expired
- Collection costs would exceed the amount owed
- You do NOT need to file a lawsuit to prove worthlessness (but document collection efforts)
How to deduct:
- Accrual basis: deduct on Schedule C (sole proprietor), Form 1120-S (S-Corp), or Form 1065 (partnership) in the year the debt becomes worthless
- Charge the amount off on your books (remove from accounts receivable)
- Keep documentation: original invoice, payment demands, correspondence, evidence of worthlessness
Statute of limitations:
- Normal: 3 years from filing date
- For bad debts: 7 years from the due date of the return for the year the debt became worthless (IRC 6511(d)(1))
- This extended period exists because determining the exact year a debt became worthless is often uncertain
How does the bad debt deduction work in practice?
Start with a Diagnostic: a CPA licensed in the US and Canada reads your file and tells you in writing what's wrong and how to fix it, three to four business days after you finish the questions. The report is $250. If you hire us for any work after that, you get the $250 back as a discount on that work. Or send us your return or your letter and get a fixed price, free.
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Yarik Yarosh, CPA. "Business Bad Debt Deduction: When and How to Write Off Uncollectible Debts." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-business-bad-debt-deduction
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.