3 good ideas for bad debts

Are you having trouble collecting money for goods or services your business has provided? Consider these three strategies for securing bad-debt deductions.

1. Prove it’s worthless. Your company can deduct a bad business debt in the year it becomes partially or totally worthless. However, if the debt isn’t worthless (i.e., it can still be collected), you’re not entitled to any deduction. If the debt is a customer receivable owed to your business, you must use the accrual method of accounting and have accrued income from the receivable to claim a later bad debt write-off.   

Strategy: Keep detailed records of all your company’s efforts to collect bad debts.

This includes any correspondence such as dunning letters, emails, telephone calls or efforts by a collection agency. These records are the best proof of worthlessness if the IRS comes calling.

2. Separate business from personal. In contrast to business bad-debt deductions, a nonbusiness bad debt is deductible only when it becomes totally worthless. Also, the debt is treated as a short-term capital loss, which can only be used to offset capital gains plus up to $3,000 of ordinary income.

Strategy: Establish in your corporate minutes that business bad debts aren’t personal advances or loans.

To be deductible as a bad business debt, a loan must be tied to your business or result in a business loss if it goes sour.

3. Pay yourself now or pay later. The IRS often questions bad-debt deductions for loans made by employee shareholders to their companies. It may say the loan represents a contribution to the capital of the employer entity.

Strategy: Make sure you’re paid a reasonable salary in the year you take a bad-debt deduction.

This shows your main motive was to protect yourself as an employee (not an employer), which will permit a bad-debt deduction if the loan isn’t repaid. Note: If you lend the company more than the compensation you’re receiving, it’s likely the advances will be treated as contributions to capital.

Tip: A nonbusiness bad-debt loss is better than nothing.