To be a bad debt, the debt must be considered “worthless. " That is, reasonable efforts must have been made to collect the debt. A debt is considered a bad debt when, even after attempting collection, there is no expectation that the debt will be repaid. [1] X Trustworthy Source Internal Revenue Service U. S. government agency in charge of managing the Federal Tax Code Go to source Business debt allows for partial deductions, whereas non-business debt requires a deduction of the entire debt amount. [2] X Research source
The other method is the allowance for doubtful accounts. This method sets aside an amount to account for bad debts before the debts are deemed uncollectible. The amount is set using estimates from historical bad debt percentages. [7] X Research source Use the method established in your bookkeeping procedures. If there is no existing method, use the direct write-off method to start. You can always use the allowance method once you know how much bad debt to expect.
For example, a $2,000 bad debt would be recorded as a debit to Bad Debt Expense for $2,000 and a credit to Account Receivable for $2,000.
For example, a $2,000 bad debt would be recorded as a debit to Bad Debt Expense for $2,000 and a credit to Account Receivable for $2,000.
The amount of the allowance can be calculated in several different ways, including as a percentage of Accounts Receivable, a percentage of total sales, or through a more complex account aging schedule. [9] X Research source For more information on estimating the allowance, see how to account for doubtful debts.
For example, a $1,000 unpaid account balance would be recorded as a debit to Allowance for Doubtful Accounts and a credit to Account Receivable, both for $1,000.
As the allowance is drawn down, Accounts Receivable goes down as well, meaning that net Accounts Receivable remains the same. [11] X Research source
For example, consider a company that has issued a long-term note to a customer with a face value of $10,000, an annual interest rate of 12 percent, and a length of 5 years. If the customer cannot pay the note, the company might consider allowing the customer to swap the note for one with a smaller interest rate or longer term. This would ease the burden on the customer. All actions taken to restructure debt should be recorded in the notes section of the financial statements.
Continuing with the example above, assume the customer owes $10,120 upon the note’s maturation (the face value plus the last year’s interest). If the entire debt is forgiven, the lender should debit Bad Debt Expense for $10,120, credit Notes Receivable for $10,000, and credit Interest Receivable for $120. [13] X Research source For notes issued to customers for the purchase of the lender’s products, it is also appropriate to transfer the Notes Receivable balance to Accounts Receivable, where it can be handled using the allowance method. In this case, the lender would debit Accounts Receivable for $10,120, credit Notes Receivable for $10,000, and credit Interest Receivable for $120.
You will have to complete a detailed bad debt statement and attach it to your return. [17] X Trustworthy Source Internal Revenue Service U. S. government agency in charge of managing the Federal Tax Code Go to source
Examples of forgiven debt susceptible to taxation are credit card debts, mortgage debts, and student loan debts (unless your job qualifies you for an exemption). [20] X Research source See IRS Publication 4681 for more details.
Avoid scam artists and offer-in-compromise companies that will claim they can make your forgiven debt tax-free. These options are expensive and will likely not work. [23] X Research source
