Every business that extends credit eventually has customers who never pay. Whether an uncollectible invoice can be deducted depends on your accounting method and on whether the debt is truly worthless. The IRS explains business bad debts in Publication 334 and on its bad debt topic page.

Cash method businesses usually cannot deduct unpaid invoices

To deduct a bad debt, the amount must have been included in income or loaned out in cash. A business using the cash method never recorded the unpaid invoice as income, so there is nothing to deduct; the income simply never arrived. This surprises many owners. See cash vs accrual accounting.

Accrual method businesses can

A business on the accrual method reports income when it is earned, including invoices not yet paid. If an invoice later becomes worthless, the business can generally deduct it as a business bad debt in the year it becomes worthless, wholly or partly.

Loans and advances

Business loans to customers, suppliers or employees that were made in cash for a business reason can become bad debts regardless of accounting method, if they become worthless. Loans to friends and family generally are not business bad debts.

Showing worthlessness

You must show that the debt is worthless and that there is no reasonable expectation of payment. You do not have to go to court if you can show a judgment would be uncollectible, but you should show reasonable collection efforts. Useful evidence includes:

  • Collection letters, emails and call notes
  • Notices of the customer's bankruptcy or business closure
  • Referral to a collection agency and its report
  • The customer's financial condition

Timing

The deduction belongs to the year the debt becomes worthless, which is a factual question. Waiting several years after collection efforts ended to write off a balance can cause problems.

Recoveries

If you collect a debt after deducting it, the recovered amount is generally included in income in the year collected, to the extent the deduction reduced tax.

In your books

We review the receivables aging every month and flag old balances; see accounts receivable for small businesses. Before year end, accrual-method clients decide which balances to write off, with documentation saved in the year-end file. Write-offs are posted to a bad debt expense account so they are visible. Our accounting services include that review.

Documenting collection efforts

Because a bad debt deduction depends on showing that a debt became worthless, keep a simple collection file for each significant balance:

  • The original invoice and any contract or signed estimate
  • Copies of reminders, statements and emails sent
  • Notes of phone calls, with dates and what was said
  • Any letters from collection agencies or attorneys
  • Bankruptcy notices, if the customer filed

You do not always have to sue to show a debt is worthless, but you should be able to show that reasonable steps were taken and that collection is not expected.

Key terms

Definitions for terms used in this guide, from our small business glossary:

  • Accrual Accounting: Accrual accounting records income when it is earned and expenses when they are incurred, regardless of when cash moves.
  • Accounts Receivable: Accounts receivable is money customers owe your business for goods or services already delivered.