Writing Off Bad Business Debts and Losses on Your Tax Return

As a business owner, you win some and you lose some. Not every sale will be profitable, and not every customer will pay their bill. But just because a business venture turned sour doesn’t mean you can’t find a silver lining come tax season. The IRS allows you to deduct qualifying bad debts and losses from your taxes, putting some of that lost money back in your pocket.

What Counts as a Bad Debt?

Let’s start with bad debts. The IRS defines a bad debt as an amount owed to you that has become totally or partially worthless. Common examples include:

• A customer who owes you money but files for bankruptcy before paying.
• Outstanding invoices that are so overdue you’ve given up hope of ever seeing payment.
• A loan you made that the borrower can no longer repay.

Basically, any time someone owes you money but it has become clear you’ll never collect it all, you have yourself a bad debt for tax purposes.

The key is being able to show it was a true debt, not just a failed investment or transaction gone bad. You need evidence like invoices, contracts, or loan agreements proving you expected repayment.

Business vs Nonbusiness Bad Debts

The IRS makes a distinction between business bad debts and nonbusiness bad debts. As the name implies, business bad debts come from your core business activities – like the examples above of customers not paying for goods or services.

Nonbusiness bad debts are from personal loans or investments outside of your trade or business. These could include:

• Loaning money to a family member who can’t pay you back.
• Investing in a friend’s business idea that flops.
• Co-signing a car loan for an ex who defaults.

The distinction matters because you can deduct business bad debts directly from your business income, while nonbusiness bad debts are treated as short-term capital losses. We’ll break down the specifics later.

How to Deduct Business Bad Debts

Business bad debts offer more flexibility at tax time. There are two options for deducting business bad debts:

1. Deduct in the Year They Become Worthless

Once you’ve exhausted collection efforts and determine a customer isn’t going to pay, you can deduct the unpaid amount as a bad debt for that tax year.

Be careful not to jump the gun – you need to demonstrate you reasonably expected payment until that point. The IRS may deny the deduction if they think you gave up too early.

2. Deduct Under the Specific Charge-Off Method

Rather than waiting until the debt is completely worthless, this method lets you deduct it as it becomes partially uncollectible.

You deduct the portion you’ve charged off in a given year, meaning the amount you’ve removed from your books because you don’t expect repayment. Then in future years you can deduct any additional amounts you have to write off as still uncollected.

The benefit is recognizing the deduction sooner when you first determine part of the debt is bad, rather than waiting until the whole thing is worthless.

How to Deduct Nonbusiness Bad Debts

If the bad debt comes from a personal loan or investment outside your business, your only option is to treat it as a short-term capital loss. Here are the specifics:

• You can claim the deduction in the year the debt becomes completely worthless, after exhausting collection efforts.
• The amount is reported on Form 8949, Sales and Other Dispositions of Capital Assets.
• You can use capital losses to offset any capital gains.
• If your capital losses exceed your capital gains, you can deduct up to $3,000 of remaining losses against your regular income.
• Any excess beyond the $3,000 limit can be carried forward to future tax years.

So while nonbusiness bad debts don’t directly lower your business income, deducting them as capital losses is the next best thing.

Bad Debt Recovery

Sometimes you deduct a bad debt, only to have the deadbeat customer show up later ready to pay! This is called a “bad debt recovery.”

If you collected on a business bad debt that was deducted in full in a prior year, report the recovered amount as taxable income. If you used the partial charge-off method, adjust the deduction on your current return.

For nonbusiness bad debts deducted as capital losses, any unexpected repayments simply reduce your total capital losses for the year collected.

Worthless Securities

Stocks, bonds, and other securities that become completely worthless are treated the same as nonbusiness bad debts – as short-term capital losses. Report them on Form 8949 and Schedule D.

Worthless securities from employer stock options given as compensation can qualify for an ordinary loss deduction, saving you more money.

Proving Worthlessness

The IRS won’t just take your word that a debt or security is worthless. Be prepared to show you made reasonable efforts to collect or sell the asset before claiming the loss, such as:

• Sending invoices and making collection calls
• Hiring a collection agency
• Filing suit and attempting to garnish wages or put a lien on property
• Listing securities for sale with a broker

Losses from Theft and Casualty

If money or property is stolen or destroyed in a casualty event like a natural disaster, the tax treatment depends on whether it was business or personal.

Business theft and casualty losses are deductible against business income. Report them on Form 4684, Casualties and Thefts.

Personal theft and casualty losses are treated as itemized deductions, subject to limitations. You must subtract any insurance reimbursement and a $100 deductible per event.

Worthless Partnership Interest

If your interest in a partnership becomes completely worthless, you can treat the loss as an ordinary loss – fully deductible against your other income. Report it on Form 8949 and Schedule D, with a note specifying it’s under IRC Section 165(g).

Abandonment Losses

If you invest in real estate or other business property that ends up worthless, you may be able to claim an abandonment loss by showing:

• You intended to use the property for business or investment purposes
• You abandoned the property because it was worthless or nearly worthless
• The property became worthless in the year you abandoned it

Abandonment losses are deducted as capital losses unless the property was business real estate, in which case the loss is ordinary.

Net Operating Losses (NOLs)

If your business deductions, including bad debts and losses, exceed your business income for the year, you have a net operating loss (NOL). You can carry back NOLs 2 years to offset past taxable income, or carry forward 20 years against future taxable income.

This creates a mechanism to realize tax savings from business losses in profitable years when the deductions are more valuable.

Consulting a Tax Pro

With all the complex rules around bad debts and losses, it’s wise to work with a tax professional to ensure you maximize deductions and report them properly. A tax pro can help document worthlessness, distinguish business vs. nonbusiness debts, and identify the optimal deduction strategy.

Don’t let deadbeat customers and other losses become a double financial hit. Deducting bad debts and casualty losses helps recover some of the funds lost, putting you in a better position to keep your business thriving.