How to Write Off Accounts Receivable as Bad Debt

To write off accounts receivable as bad debt for federal tax purposes, you need to clear one gate before anything else: the unpaid amount must already sit in your reported income, or represent cash you actually lent out. Under 26 U.S.C. § 166, a business can deduct a debt that becomes worthless during the tax year only if it was previously included in gross income or reflects money that left your pocket.¹ From there, the process is: prove the debt is worthless, charge it off in your books, report it on the right form for your entity, and keep the paperwork for seven years.

First, Confirm Your Accounting Method

If your business uses the accrual method, you record revenue when you earn it. An unpaid invoice is already in your reported income, so you can deduct it as a bad debt when the customer fails to pay. If your business uses the cash method, you only record revenue when the money arrives. Because the income from an unpaid invoice was never on your return, there is nothing to deduct. The IRS considers you whole since you were never taxed on that money.²

This is the mistake that trips up more small-business owners than any other part of the process. Most sole proprietors and small LLCs are cash-basis, and most cash-basis unpaid invoices simply aren’t eligible for a bad debt deduction. The exception is when you actually loaned cash to a customer or client. That money left your pocket, so you have a basis in the debt and can deduct it if it becomes worthless.²

You may still want to write the receivable off in your books to keep your balance sheet honest. Just don’t expect a federal tax benefit if you’re cash-basis and the loss is an unpaid invoice.

Establish That the Debt Is Actually Worthless

Section 166 allows a deduction for a debt that becomes wholly worthless during the tax year, and also allows a partial deduction when only a portion is unrecoverable.¹ “The customer hasn’t paid” is not enough on its own. You need to show you made reasonable efforts to collect and that further efforts would be pointless.

You do not have to sue the debtor. You do need to demonstrate that a court judgment would be uncollectible, meaning the debtor has no attachable assets or income that could satisfy the debt.² Common evidence includes bankruptcy filings, insolvency records, a business closure, or documented attempts to negotiate payment that went nowhere. The stronger your paper trail, the less likely the IRS is to challenge the deduction on audit.

For a wholly worthless debt, you deduct the full remaining balance. For a partially worthless debt, you can only deduct the portion you have actually charged off on your books during the tax year. The IRS will not let you deduct more than you have written off in your own records.¹

Related-Party Debts

Loans to relatives, friends, or affiliated businesses draw closer IRS attention. You need to prove the transaction was a genuine loan and not a gift, meaning there was a real expectation of repayment at the time you made it. If you lent money to a family member with the understanding they might not repay it, the IRS treats that as a gift, and no deduction is available.² Written loan agreements, promissory notes, and evidence of scheduled payments help establish that a real debtor-creditor relationship existed.

Charge the Debt Off on Your Books

For federal tax purposes, the IRS requires most taxpayers to use the specific charge-off method. You deduct a bad debt only when you can identify a specific debt that has become worthless during the tax year. No estimates, no reserves, just actual identified losses.¹

If you keep GAAP-compliant financial statements, you may also maintain an Allowance for Doubtful Accounts on your books that estimates future losses. That allowance has no effect on your tax return. Your GAAP books can show a $50,000 allowance for doubtful accounts while your tax return deducts only the specific amount you identified and charged off that year. Keep the two records straight; a reserve estimate is not a deduction.

Report the Deduction on the Right Form

Business bad debts are ordinary deductions, so they reduce income dollar for dollar rather than being subject to capital loss limits. The form depends on how your business is organized:

Sole proprietors and single-member LLCs report on Schedule C (Form 1040) under Other Expenses.²
C corporations report on Form 1120, Line 15.
S corporations report on Form 1120-S, Line 10.³
Partnerships and multi-member LLCs report on Form 1065, Line 12.

Entity type also affects partial worthlessness. Corporations can deduct partially worthless debts with IRS approval, while individuals claiming nonbusiness bad debts can only deduct debts that are totally worthless. If your debt is only partially unrecoverable, this is a good point to bring in a tax professional.

Take the Deduction in the Correct Year

The deduction belongs in the specific tax year the debt becomes worthless, not the year the invoice was originally due, and not whenever you get around to cleaning up your books.² You do not have to wait until the due date passes. If a customer files for bankruptcy in March and their assets clearly will not cover your invoice, you can treat the debt as worthless in that same year.

Missing the correct year is not always fatal. Federal law gives you seven years from the original return due date to file an amended return claiming a bad debt deduction, compared with the standard three-year window for most other amendments.⁴ Pinpointing the exact year a debt became worthless can be genuinely difficult, which is why the window is longer. Still, getting the year right the first time avoids the amendment.

Documentation to Attach and to Keep

Build your file before you claim anything. The IRS expects the original contract or invoice establishing the debt, records of every collection attempt (call logs, emails, demand letters), and evidence showing why you concluded the debt was worthless. Bankruptcy notices, court records, and returned mail from a debtor who vanished all count.

For nonbusiness bad debts, and as a best practice for business bad debts, attach a detailed statement to your return. That statement should include:

A description of the debt, including the amount and the date it became due
The debtor’s name and any business or family relationship between you and the debtor
The collection efforts you made
The basis for your determination that the debt is worthless

Be specific. “Customer went out of business” carries more weight than “customer didn’t pay.” A bankruptcy docket number or a returned certified letter gives the statement teeth.²

The IRS gives itself seven years to examine returns that include a bad debt deduction, so your record retention should match. Keep all supporting documentation for at least seven years from the date you filed the return.⁵

If the Customer Later Pays

Sometimes a customer you wrote off eventually pays. Under the tax benefit rule in 26 U.S.C. § 111, if you recover money on a previously deducted bad debt, you generally must include the recovered amount in gross income for the year you receive it.⁶ You got a tax break when you wrote it off, so the IRS wants that break reversed when the money comes back.

One exception matters. If the original deduction did not actually reduce your tax, say you had enough other losses that year to zero out your tax liability, the recovered amount is not taxable income. You owe tax on the recovery only to the extent the deduction provided an actual benefit.⁶

Nonbusiness Bad Debts Follow Different Rules

If the debt does not arise from a trade or business (a personal loan to a friend or family member, for example), it is a nonbusiness bad debt, and the rules are less favorable. It is treated as a short-term capital loss, subject to the annual capital loss deduction limit of $3,000 ($1,500 if married filing separately), with any unused loss carrying forward.⁷

A nonbusiness bad debt must be totally worthless to be deductible. Partial write-offs are not allowed. Report it on Form 8949, Part I, with box C checked, entering the debtor’s name and “bad debt statement attached” in the description column, your basis in column (e), and zero for proceeds in column (d).⁷ The detailed statement described above must be attached.

Penalties for Overreach

Claiming a bad debt deduction you do not qualify for, or inflating the amount, exposes you to an accuracy-related penalty of 20% of the underpaid tax.⁸ That percentage rises to 40% for gross valuation misstatements. If the IRS determines the deduction was fraudulent (intentionally deceptive rather than merely wrong), the penalty rises to 75% of the underpayment attributable to fraud.⁹ The fraud penalty is rare in routine bad debt cases, but overstating worthlessness or fabricating collection efforts is exactly the kind of conduct that can trigger it.

1
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
2
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
3
Internal Revenue Service. Instructions for Form 1120-S (2025)
4
Internal Revenue Service. Time You Can Claim a Credit or Refund
5
Internal Revenue Service. How Long Should I Keep Records
6
Office of the Law Revision Counsel. 26 USC 111 – Recovery of Tax Benefit Items
7
Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
8
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
9
Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty