What bad debt is and how to manage it in your business

Executive overview

Bad debt is money owed to your business that cannot be collected. It is an unavoidable cost for any organisation that extends credit to customers.

The IRS distinguishes two types: business bad debts (from credit sales or loans to clients, suppliers, or employees) and non-business bad debts (personal unpaid loans). Business bad debts can be deducted from gross income, but only after reasonable collection efforts have been made.

Extending credit always carries the risk of unrecoverable loss — managing accounts receivable proactively is the primary defence.

Good debt vs. bad debt

• Not all debt is harmful: debt likely to be repaid (mortgages, business loans for future growth) is considered good
• Bad debt results in a direct loss of assets or profit
• Any uncollected portion of accounts receivable (AR) is classified as business bad debt

IRS rules and tax deductions

• Business bad debt: losses from debts created or acquired in the course of business operations
• Non-business bad debt: all other uncollected debts, such as personal loans
• Bad debts can be deducted from gross income when calculating taxable income
• The amount owed must have been included in gross income for the year of deduction or a prior year
• Use the profit or loss from business (sole proprietorship) tax return form to claim the deduction
• The debt must be genuinely uncollectible — reasonable collection efforts must precede any deduction claim

Avoiding and reducing bad debt

• Create a documented communication pathway for following up with customers, vendors, and suppliers
• Develop a clear invoicing timeline with defined consequences for late payment
• Project an assertive, consistent stance on payment to clients
• Monitor AR continuously — spot and act on patterns of repeated default early
• Cut ties with persistently defaulting clients before the relationship costs more than it earns