What Is a Bad Debt Deduction?

A bad debt deduction is a type of tax deduction that is extended by a revenue agency to lenders and various types of businesses. A deduction of this type makes it possible to claim a portion of any outstanding balances owed to the taxpayer by clients that have been written off as bad debt. The actual amount of the deduction will depend on the total amount of bad debt claimed for the tax period and the formula that is used by the revenue agency to determine how much of a deduction is allowed.

In order to claim a bad debt deduction, the taxpayer must meet the criteria set forth by the revenue agency. This often means that the debt in question must be aged past a certain amount of time, a measure that prevents last-minute declarations of bad debt just before the tax year closes. In addition, the taxpayer must also be prepared to verify that what constitutes a reasonable effort to collect the debt took place. Many tax agencies place a limit on the amount of bad debt that can be deducted within a tax year, often based on the reported income of the taxpayer for that period. Most agencies will provide worksheets that can aid in estimating deductions and determining what percentage of the actual debt can be claimed as a bad debt deduction.

One of the benefits of the bad debt deduction is that this type of tax break helps to offset some of the loss sustained by a company or other entity due to customers defaulting on the balances of credit accounts, goods, and services sold and billed by way of an invoice, or even defaults on loans or lines of credit. While the deduction will not cover the entire loss sustained, the amount claimed can help to offset gains in other areas, which means that the taxpayer will owe fewer taxes for the period. This means that more of the collected revenue remains with the taxpayer and at least offsets a small portion of the lost revenue represented by the total bad debt.

As is true of tax laws in general, the conditions for claiming a bad debt deduction are subject to change from one tax year to the next. For this reason, it is important to identify any updates to tax laws that may affect the amount of bad debt that can be claimed. Typically, a tax professional will be aware of any changes in these laws, and can advise clients on what to expect in terms of the ability to make some sort of deduction based on outstanding receivables written off as bad debt.