If you've been in business for any length of time, you know that bad debts are a fact of life for an entrepreneur.
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In an ideal world, you would prefer to have no uncollected unreceivables. But since you live in the real world, you can take comfort in knowing that at least you can take a tax deduction for bad debts.
It would be great if the IRS just took your word for the total value of receivables that you're sure you won't be able to collect. However, since they are the IRS, certain limitations apply regarding the deductibility of bad debts. To meet IRS requirements, you have to be able to prove that a legal relationship exists between you and the debtor, that the receivables are truly worthless, and that your business suffered an actual loss as a consequence.
Requirement #1: Proof of a Legal Relationship
Of the three IRS requirements, this is probably the easiest to prove. A legal relationship can be said to exist if a client or customer has a legitimate obligation to provide payment. You should be able to prove your relationship to the debtor through a variety of resources including invoices, contracts, or other business documents.
Requirement #2: Proof That the Receivable is Uncollectable
The second IRS requirement is only slightly more difficult to prove than the first one. Somehow you have to be able to prove that the debt is completely devoid of value and has a miniscule chance of becoming collectable at some point in the near future. You also have to be able to prove that you have taken action toward the collection of the debt, even if though those actions were unsuccessful. Although you don't necessarily have to take legal action to prove that you have tried to collect the debt, you should maintain a record of the letters and notices you have issued the debtor in your attempts to collect the receivable.
Requirement #3: Proof That the Business Sustained Actual Losses
By far, the IRS's third requirement is both the most difficult to prove and the least popular among small business owners. Before they are willing to grant a deduction for a bad debt, the IRS wants to make sure that the debt has already been included as income for the business. For that to happen, your business will need to employ an accrual method of accounting. An example of a deductible bad debt would be the price of a product that was sold to a customer on credit, was subsequently recorded as income, but was never actually paid. Other limitations could also apply since the IRS takes a negative of view toward writing off the value of your time and effort as a bad debt.
If an uncollected receivable meets the IRS requirements, it can only be deducted in the year it becomes worthless. On the other hand, if the debt doesn't meet IRS qualifications, you can still deduct the costs involved in the creation of the product or service as normal business expenses.