Operating a business means you often have to deal with late paying clients. Additionally, you will have to deal with clients who do not pay invoices because a customer closes their doors and goes out of business. The Internal Revenue Service (IRS) has specific rules about writing off uncollected debt. The methods for writing off business debt often depend on the method that a company determines is more feasible for them. Additionally, the IRS also has time limits for writing off uncollected debt that must be kept in mind. Companies who fail to claim the uncollected debt within two tax periods may be unable to deduct the loss on their taxes.
Before writing off a bad debt, it is important to verify all internal accounting records. This includes reviewing all outstanding invoices and contracts. It is important to stop any automatic shipments or scheduled services immediately. In addition, confirmation must be obtained that the company has gone out of business.
To confirm the company status, any documentation that has been received from the company, confirmation from a bankruptcy court or recordings from the Secretary of State should be obtained. These records should be maintained with tax records for the year that the loss is claimed.
Companies that have filed bankruptcy must notify all creditors. In this case, you may file a claim in court for the amount that is owed. While not all bankruptcy proceedings result in creditors being satisfied, in part or in full, it is possible that you may be able to collect all or part of what is owed to your company.
Internal Accounting Procedures
To record a loss of income internally, you will need to post an entry to eliminate any income that was anticipated from the defunct company. Fortunately, this process is not difficult as it only requires a journal entry to eliminate the outstanding monies from your potential income. This is an important entry since otherwise your balances due will be inflated by the amount of the outstanding invoices.
A simple journal entry will eliminate the debt from the records of your company. The journal entry should specify that the amount is being written off as a bad debt. This may be accomplished by naming a category called bad debt. The entire amount that is owed to your company should be entered against the client account.
Most companies, depending on their size, have specific codes for bad debt. The bad debt recording is listed as a negative entry against accounts receivables. Some companies maintain an accounts receivable ledger as well as individual client ledgers. If your company uses both, make sure that the entries are done in both ledgers to avoid accounting conflicts later. The process is the same for both paper and electronic bookkeeping methods
The IRS allows business owners to determine the best way to write off debt on their income. The two methods are charge-off and non-accrual experience. Both have slightly different requirements which must be adhered to. In order to use the non-accrual experience method, a company must have at least $5 million in gross receipts. In addition, most of their business must involve services. Generally, doctors, lawyers and accountants may use this method. Companies that sell products nearly always use the charge-off method. The charge-off method also has specific requirements.
Companies who are using the charge-off method may deduct all or part of a debt on their taxes. Partial debt may be written off on internal books and reported as a partial loss. This option may be used if only part of the debt is considered bad. The IRS does not require companies to deduct bad debt annually; bad debt may be held for an additional tax year. In this instance, you may also deduct the full amount of the loss one year later if the full debt becomes worthless.
For those who have not claimed a bad debt on their taxes, there may be an option to file a new return claiming the bad debt writeoff. The IRS provides businesses the opportunity to file a new return within seven years of the original tax due date or within two years if a tax was paid on the income for worthless debt. For partially worthless debt, a new return may be filed three years from the original filing or two years from paying the tax on bad debt
Records Retention and Accuracy
Unfortunately, when a company goes out of business, it impacts not only their company but the companies where they contracted for products or services. For a company to write off bad debt, the requirements laid out by the Internal Revenue Service must be adhered to. In addition, should a business later be able to recuperate part of the bad debt loss, the full amount that is recovered must be claimed as income. Fortunately, the recording of bad debt is fairly straightforward. Companies typically do not have to hire an accountant to deal with bad debt, since it is a straightforward bookkeeping entry.
Once a debt is determined to be a bad debt, it is important that a company maintains full records. This is critical in the event of an IRS audit. In some cases, the IRS will require that the business prove they wrote off the bad debt accurately. This may involve showing invoices, contracts and documentation that shows that attempts were made to collect the debt.
- Internal Revenue Service: Topic 453 – Bad Debt Deduction
- JSU College of Commerce and Business Administration: The Allowance Method of Accounting for Bad Debts
- Bankrate: Deducting a business loss
- Internal Revenue Service: Business Bad Debts