Can our law firm write off bad debts?

CosmoLex Team

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Bad Debts

Bad debt is when a customer won’t pay their bill and you can’t collect it. It’s frustrating but you don’t have to take a total loss on bad debt. You may be able to take a deduction for them. However, there are caveats to this. To write off bad debt, it must meet several requirements.

First and foremost, the debt must be a bona fide debt owed to you. You’ll need to have proof of services rendered, the payment agreed upon, and failure on the client’s part to deliver payment. Written proof of the debt provides the strongest documentation, but oral agreements are possibly enforceable.

You also need to demonstrate a basis in the debt. A basis in debt occurs when you’ve already included the amount they owed you in your firm’s gross income for the year. This means you’ve treated the money as taxable for that tax year, and therefore owed to you as paid[1].

To be written off, your debt needs to have arisen from your business activities. Personal debts can’t be deducted. These are, as per the IRS, nondeductible gifts unless there is substantial documentation otherwise.

Finally, your debt needs to be considered at least partially worthless. A debt is considered worthless if there’s no chance of being paid. This doesn’t mean you have to send your client’s account to collections or file a lawsuit against them. In fact, you don’t even need to wait until the total amount of the debt is due.

You do, however, need to show that you’ve taken reasonable measures to collect the debt. It’s also sufficient to demonstrate that any efforts at collection would be futile. This might include:

  • Repeated and unsuccessful attempts to collect
  • Proof that the debtor filed for bankruptcy or has been through bankruptcy to have all or part of the debt forgiven
  • The debtor has gone out of business, died, or disappeared

As with any financial issues, keep all documentation of bad debt situations. Unpaid invoices, collection letters, credit reports, anything that documents the activities.

Timelines are important to remember with all tax issues. The bad debt needs to be deducted in the year that it becomes totally worthless. If you’re dealing with a partially worthless debt, you can deduct the unpaid portion that year or wait until the next to deduct it.

When it comes to claiming bad debts, they’re reported as ordinary losses on Form 1040 on a Schedule C, F, or A. If the bad debt wasn’t deducted on your original return the year it became worthless, you can file for a credit or refund. If you missed filing a deduction on your return the year the debt became worthless, it may not be too late. If the bad debt is considered totally worthless, you can file a claim[2]:

  • Seven years from the date your original return was due, excluding any filing extensions OR
  • Two years from the date you paid the tax

For partially worthless debts, you can file up to:

  • Three years from the date you filed the return OR
  • Two years from the date you paid the tax

What happens, though, if you recover a bad debt? In terms of your taxes, the amount recovered is considered gross income to the extent you claimed the debt as a deduction in the previous tax year, which reduced your taxable income as per the tax benefit rule.


References

1. Deduction for Business Bad Debts
2. Deducting Receivables as Bad Business Debts