When Is a Bad Debt Not a Tax Deduction?

One area that can cause a difference between book income and taxable income is writing off bad debts. Generally accepted accounting principles require that an allowance be set up against accounts receivable to attempt to match up the amounts that are earned in the current year, and therefore included in income during the year, with an expense for the portion of that income that will not be collected. However, tax rules do not allow for a deduction based on an unspecified reserve for bad debts.

For tax purposes, bad debts can only be deducted when they are specifically identified. What this means is that no matter what method is used for financial statement preparation, only bad debts that can be specifically identified are allowed to be counted as a deduction for tax purposes. If a Company chooses to use an allowance method in which a certain percentage of accounts receivable is reserved for, the amount reserved cannot be deducted against current income. However, a reserve against accounts receivable may be deducted for tax purposes if the reserve is made up of specifically identified accounts.

One method that is used for financial statement preparation in accordance with generally accepted accounting principles is a specifically identified reserve for bad debts. In this case, specific accounts are identified as uncollectible and are accounted for in a reserve. They are not necessarily completely taken out of accounts receivable at the time they are written off, but are placed in the reserve account. When this method is used the amounts recorded in the bad debt reserve are allowed to be deducted for tax purposes. Another method that may be used if it is not significantly different in results from the allowance method is the direct write-off method. Companies that use this method simply write off bad debts when they believe they are no longer collectible. When bad debts are recorded in this way, there is also no difference between book income and taxable income.

So what is the effect of the difference in tax rules and generally accepted accounting principles regarding the writing off of bad debts? If a general reserve is used for accounting for bad debts in the financial statements, there will be a book to tax difference for the amount of the allowance for bad debts. The taxable income will be higher by the amount of the reserve. If a reserve has already been established in the prior fiscal year, then the difference in book income and taxable income will be the change in the reserve. This could result in higher or lower taxable income depending on the direction of the change in the reserve. If the reserve increases, your taxable income will be higher than book income by the amount of the change. If the reserve decreases, your taxable income will be lower by the amount of the change for that year.

If the Company is a C Corporation and is using a general reserve for bad debts, it will always have a deferred tax asset related to the reserve. The deferred tax asset would generally be calculated by multiplying the reserve by the Company's estimated tax rate. The deferred tax asset represents the amount of taxes that has been paid by the Company related to bad debts that have been recorded in the financial statements, but are not allowed to be deducted in the tax return.

Finally, no matter what method is used to account for bad debts for book purposes, it is important to consider the timing of when a bad debt is recorded for tax purposes. If an amount is specifically identified as uncollectible, the Company can deduct it for tax purposes. Because it is always beneficial to take a deduction sooner rather than later, it is advisable to take the deduction as soon as an account is identified as being uncollectible. So no matter what method is being used, an account should be written off as a bad debt when it is considered very unlikely that it will be collected. If a receivable that has been written off is later collected, it will just be recorded as income in the period it is received. The one thing to be careful of is to not abuse the recording of bad debts and begin to write off accounts as bad debts when they still may be collected. If the Company is audited and the IRS determines that some of the bad debts should not have been written off, they will require the taxes on them to be paid with interest and penalties attached.