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Bad Debts That You Cannot Collect

  Sanjiv Gupta CPA  Published 
Bad Debts That You Cannot Collect

In today’s high cost of living, saving money is a big challenge. There are business expenses, personal expenses, tax payable to the government and more. It seems like the expenses are never-ending. However, there are certain costs for which taxes can be written-off. One such category is bad debts that you cannot collect.

A bad debt, as we all know, is that money that you cannot recover. Bad debts are of two kinds – business bad debts and non-business bad debts.

 Business Bad Debts

Any amount that comes as an expense from the operations of your business is regarded as a business bad debts. This amount can be deducted from your business tax return. A typical business bad debt would include the loss incurred due to debt. This could either be:

  • An expense resulting from your business operations
  • An expense closely related to the business which is of minimal value now

An expense has close relations with your business if the motive for which it was acquired is associated with your business.

Business owners face bad debts when they sell products or services on credit. Other cases of debts include loans granted to clients, distributors, suppliers or employees. As per accounting norms, the cost of goods and services for which customers have not paid comes under notes or accounts receivable. When you are unable to obtain this amount of money, it is recognized as bad debts that you cannot collect.

Bad debts can be deducted or waived off from your tax return only if the amount was mentioned in your gross income. These accounts or notes receivable should be in the books of the year for which deduction is being claimed or in the books of the year prior to that. Below mentioned are two methods for deduction:

 Accrual Method: As per the accrual method, income is reported when you earn it. If you follow this method of accounting, then you will be eligible to get a deduction for bad debts that you cannot collect if the uncollectable amount has been recorded in income.

 Cash Method: As per the cash method, income is reported when payment is received. Of course, bad debt will never be reported because you did not receive the payment for it. If your accounting books follow this method, then you are not eligible for any bad debt deduction. This is because the amount that you have not collected is not included in the amount for income.

 Non-business debts

These include the money that you were unable to collect but had no relevance to your business. These are bad debts generated from other activities and are deductible under the category of short-term capital losses as per Form 8949 and Schedule D (Form 1040).

Next time when you file your tax return, make sure that you are able to apply for bad debt deductions, if applicable and save money on that.