Bad Debt Deduction: When Unpaid Invoices Are Deductible
Business vs nonbusiness bad debts, the worthlessness test, and why cash-method businesses usually cannot deduct an unpaid invoice
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A bad debt deduction under section 166 lets a taxpayer deduct a bona fide debt that has become worthless. A business bad debt is an ordinary loss, deductible even when partly worthless; a nonbusiness bad debt is a short-term capital loss, deductible only when wholly worthless. An unpaid invoice is deductible only if the income was first reported.
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What is a bona fide debt?
A genuine debtor-creditor relationship with a valid, enforceable obligation to pay a fixed or determinable sum. A loan to a customer with a note, an account receivable for goods delivered, a guarantee paid on a borrower's default — these qualify. Advances to a family member with no expectation of repayment, capital contributions labeled as loans, and money given without terms are gifts or investments, not debts, however they are described. The IRS looks at a written instrument, a fixed repayment schedule, interest, security, and whether repayment was actually pursued.
Business or nonbusiness?
| Business bad debt | Nonbusiness bad debt | |
|---|---|---|
| Arises from | The taxpayer's trade or business — accounts receivable, loans to customers or suppliers, loans made as part of a lending business, employee loans to protect a job | Everything else — personal loans, loans to friends and relatives, most shareholder loans to one's own corporation (unless made to protect employment as the dominant motive) |
| Deducted as | Ordinary loss (Schedule C, or the business return) | Short-term capital loss (Form 8949 / Schedule D), limited to US$3,000 a year (US$1,500 married filing separately) against ordinary income after capital gains |
| Partial worthlessness | Deductible to the extent charged off on the books | Not deductible — wholly worthless only |
| Timing | The year the debt becomes wholly or partly worthless | The year it becomes wholly worthless |
| Recovery later | Income in the year recovered (to the extent the deduction produced a tax benefit) | Same |
The shareholder-loan question is the contested one: a shareholder who lends to their own corporation and is not repaid usually has a nonbusiness bad debt (a capital loss, US$3,000 a year) unless they can show the loan's dominant motive was protecting their salary as an employee rather than their investment — a fact-heavy argument the courts have decided both ways.
Why can't a cash-method business deduct an unpaid invoice?
Because a bad debt deduction requires basis in the debt, and a cash-method business has none in a receivable it never included in income. An accrual-method business records the sale as income when billed, so the receivable has basis equal to the income reported; when it becomes worthless, the deduction reverses the income. A cash-method business records income only when paid; an invoice that is never paid was never income, and deducting it would deduct something that was never taxed. The cash-method business's "loss" is real economically — the labor and materials went into the job — but those costs were already deducted when paid. The unpaid invoice is simply not income, which is the same result.
What is worthlessness?
A debt is worthless when there is no reasonable expectation of collection — the debtor is bankrupt, has disappeared, has no assets, or has refused to pay and collection would cost more than the debt. Legal action is not required; a reasonable business judgment, documented, is enough. But the deduction must be taken in the year worthlessness occurs, not a convenient later year — and a debt that is merely overdue or disputed is not worthless. For partial worthlessness of a business debt, the amount must actually be charged off on the books in the year deducted.
How is the deduction claimed?
Business bad debts: on Schedule C (Part V, other expenses, carried to line 27b) or the business return, using the specific charge-off method — each worthless debt identified and charged off individually (the reserve method is not permitted for tax). Nonbusiness bad debts: on Form 8949 as a short-term capital loss with a statement describing the debt, the debtor, the relationship, the efforts to collect, and why it is worthless. Keep the loan documents, the collection correspondence, and the evidence of the debtor's condition.
Worked example
An accrual-method HVAC contractor billed a builder US$38,000 for a commercial install, reported it as income, and was never paid; the builder filed bankruptcy eighteen months later with no assets for unsecured creditors. Business bad debt: US$38,000 deducted as an ordinary loss in the year it became worthless — here, the year of the bankruptcy filing that showed no assets for unsecured creditors — reversing the income reported earlier. A cash-method plumber in the same building billed the same builder US$14,000 and was never paid: no deduction — the US$14,000 was never reported as income, and the parts and labor were deducted when paid. The plumber's brother-in-law, who personally lent the builder US$25,000 on a signed note with interest: a nonbusiness bad debt when the bankruptcy made it wholly worthless — a US$25,000 short-term capital loss, usable at US$3,000 a year against ordinary income (faster against capital gains). And the builder's own shareholder, who advanced US$60,000 to the company as "loans" with no notes and no repayment terms: a capital contribution, not a debt — a capital loss on worthless stock, not a bad debt.
Frequently asked questions
Can I deduct an invoice a customer never paid?
Only if you use the accrual method and reported the invoice as income. A cash-method business never reported it, has no basis in the receivable, and has nothing to deduct — the costs of the job were deducted when paid.
What is the difference between business and nonbusiness bad debt?
A business bad debt arises from your trade or business and is an ordinary loss, deductible in full and even when partly worthless. A nonbusiness bad debt is a short-term capital loss, deductible only when wholly worthless and subject to the US$3,000 annual capital loss limit.
How do I prove a debt is worthless?
Show there is no reasonable expectation of collection: bankruptcy, the debtor's insolvency or disappearance, or documented collection efforts that failed. Legal action is not required; the deduction is taken in the year worthlessness occurs.
Can I deduct a loan to a family member?
Only if it was a bona fide debt — a real obligation with terms, interest, and expected repayment — and it has become wholly worthless. Then it is a nonbusiness bad debt (short-term capital loss). A loan with no expectation of repayment is a gift.
Official sources
Topic no. 453 states: “Generally, a business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless.” — Internal Revenue Service, Topic no. 453, Bad debt deduction, https://www.irs.gov/taxtopics/tc453
Publication 538 states: “Under an accrual method of accounting, you generally report income in the year it is earned and deduct or capitalize expenses in the year incurred.” — Internal Revenue Service, Publication 538, Accounting Periods and Methods, https://www.irs.gov/publications/p538
Next step
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