Bad Debts: Small-Business Taxes (2025 IRS Guide)

This guide covers “Bad Debts” within small-business taxes. The following material presents the IRS treatment of this topic, including the qualifications, exceptions, and examples in the source section. Read the rules alongside the facts of your own situation before deciding what to report, deduct, or document.

Adapted from Publication 334 (2025), Tax Guide for Small Business, published by the Internal Revenue Service. This guide retains the source edition’s years, amounts, deadlines, and examples. It is guidance for that edition, not a statement that the same figures apply to every tax year.

Bad Debts

If someone owes you money you can’t collect, you have a bad debt. There are two types of bad debts—business bad debts and nonbusiness bad debts.

A business bad debt is generally one that comes from operating your trade or business. You may be able to deduct business bad debts as an expense on your business tax return.

Business bad debt.

A business bad debt is a loss from the worthlessness of a debt that was either of the following.

1. Created or acquired in your business.

2. Closely related to your business when it became partly or totally worthless.

A debt is closely related to your business if your primary motive for incurring the debt is a business reason.

Business bad debts are mainly the result of credit sales to customers. They can also be the result of loans to suppliers, clients, employees, or distributors. Goods and services that customers have not paid for are shown in your books as either accounts receivable or notes receivable. If you are unable to collect any part of these accounts or notes receivable, the uncollectible part is a business bad debt.

.You can take a bad debt deduction for these accounts and notes receivable only if the amount you were owed was included in your gross income either for the year the deduction is claimed or for a prior year. .

Accrual method.

If you use an accrual method of accounting, you normally report income as you earn it. You can take a bad debt deduction for an uncollectible receivable if you have included the uncollectible amount in income.

Cash method.

If you use the cash method of accounting, you normally report income when you receive payment. You can’t take a bad debt deduction for amounts owed to you that you have not received and can’t collect if you never included those amounts in income.

Debts from a former business.

If you sell your business but retain its receivables, these debts are business debts because they arose out of your trade or business. If any of these receivables subsequently become worthless, the loss is still a business bad debt.

Debt acquired from a decedent.

The character of a loss from debts of a business acquired from a decedent is determined in the same way as debts acquired on the purchase of a business. The executor of the decedent’s estate treats any loss from the debts as a business bad debt if the debts were closely related to the decedent’s trade or business when they became worthless. Otherwise, a loss from these debts becomes a nonbusiness bad debt for the decedent’s estate.

Liquidation.

If you liquidate your business and some of the accounts receivable that you retain become worthless, they’re treated as business bad debts.

Types of Business Bad Debts

Business bad debts may result from the following.

Loans to clients and suppliers.

If you loan money to a client, supplier, employee, or distributor for a business reason and you’re unable to collect the loan after attempting to do so, you have a business bad debt.

Debts owed by political parties.

If a political party (or other organization that accepts contributions or spends money to influence elections) owes you money and the debt becomes worthless, you can claim a bad debt deduction only if all of the following requirements are met.

1. You use an accrual method of accounting.

2. The debt arose from the sale of goods or services in the ordinary course of your trade or business.

3. More than 30% of your receivables accrued in the year of the sale were from sales to political parties.

4. You made substantial and continuing efforts to collect on the debt.

Loan or capital contribution.

You can’t claim a bad debt deduction for a loan you made to a corporation if, based on the facts and circumstances, the loan is actually a contribution to capital.

Debts of an insolvent partner.

If your business partnership breaks up and one of your former partners becomes insolvent, you may have to pay more than your pro rata share of the partnership’s debts. If you pay any part of the insolvent partner’s share of the debts, you can claim a bad debt deduction for the amount you paid that is attributable to the insolvent partner’s share.

Business loan guarantee.

If you guarantee a debt that subsequently becomes worthless, the debt can qualify as a business bad debt if all of the following requirements are met.

• You made the guarantee in the course of your trade or business.

• You have a legal duty to pay the debt.

• You made the guarantee before the debt became worthless. You meet this requirement if you reasonably expected you wouldn’t have to pay the debt without full reimbursement from the borrower.

• You received reasonable consideration for making the guarantee. You meet this requirement if you made the guarantee according to normal business practice or for a good faith business purpose.

Example.

Finley Zayne owns the Zayne Dress Company. Finley guaranteed payment of a $20,000 note for Elegant Fashions, a dress outlet. Elegant Fashions is one of the dress company’s largest clients. Elegant Fashions later defaulted on the loan. As a result, Finley paid the remaining balance of the loan in full to the bank.

Finley can claim a business bad debt deduction only for the amount Finley paid because the guarantee was made in the course of Finley’s trade or business for a good faith business purpose. Finley was motivated by the desire to retain one of Finley’s better clients and keep a sales outlet.

Deductible in the year paid.

If you make a payment on a loan you guaranteed, you can deduct it in the year paid, unless you have rights against the borrower.

Rights against a borrower.

When you make payment on a loan you guaranteed, you may have the right to take the place of the lender. The debt is then owed to you. If you have this right, or some other right to demand payment from the borrower, you can’t claim a bad debt deduction until these rights become partly or totally worthless.

Joint debtor.

If two or more debtors jointly owe you money, your inability to collect from one doesn’t enable you to deduct a proportionate amount as a bad debt.

Sale of mortgaged property.

If mortgaged or pledged property is sold for less than the debt, the unpaid, uncollectible balance of the debt is a bad debt.

When a Debt Becomes Worthless

A debt becomes worthless when there is no longer any chance the amount owed will be paid. This may occur on the date the debt is due or prior to that date.

To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so.

Property received for debt.

If you receive property in partial settlement of a debt, reduce the debt by the property’s fair market value, which becomes the property’s basis. You can deduct the remaining debt as a bad debt if and when it becomes worthless.

If you later sell the property for more than its basis, any gain on the sale is due to the appreciation of the property. It isn’t a recovery of a bad debt. For information on the sale of an asset, see Pub. 544.

How To Claim a Business Bad Debt

There are two methods to claim a business bad debt.

• The specific charge-off method.

• The nonaccrual-experience method.

Generally, you must use the specific charge-off method. However, you may use the nonaccrual-experience method if you meet the requirements discussed later under Nonaccrual-Experience Method.

Specific charge-off method.

If you use the specific charge-off method, you can deduct specific business bad debts that become either partly or totally worthless during the tax year. However, with respect to partly worthless bad debts, your deduction is limited to the amount you charged off on your books during the year.

Partly worthless debts.

You can deduct specific bad debts that become partly uncollectible during the tax year. Your tax deduction is limited to the amount you charge off on your books during the year. You don’t have to charge off and deduct your partly worthless debts annually. You can delay the charge-off until a later year. However, you can’t deduct any part of a debt after the year it becomes totally worthless.

There are two rules regarding charge-off debts to consider.

• Significantly modified debt. An exception to the charge-off rule exists for debt that has been significantly modified and on which the holder recognized gain. For more information, see Regulations section 1.166-3(a)(3).

• Deduction disallowed. Generally, you can claim a partial bad debt deduction only in the year you make the charge-off on your books. If, under audit, the IRS doesn’t allow your deduction and the debt becomes partly worthless in a later tax year, you can deduct the amount you charged off in that year plus the disallowed amount charged off in the earlier year. The charge-off in the earlier year, unless reversed on your books, fulfills the charge-off requirement for the later year.

Totally worthless debts.

If a debt becomes totally worthless in the current tax year, you can deduct the entire amount minus any amount deducted in an earlier tax year when the debt was only partly worthless.

You don’t have to make an actual charge-off on your books to claim a bad debt deduction for a totally worthless debt. However, you may want to do so. If you don’t and the IRS later rules the debt is only partly worthless, you will not be allowed a deduction for the debt in that tax year because a deduction of a partly worthless bad debt is limited to the amount actually charged off. See Partly worthless debts, earlier.

Filing a claim for refund.

If you didn’t deduct a bad debt on your original return for the year it became worthless, you can file a claim for a credit or refund. If the bad debt was totally worthless, you must file the claim by the later of the following dates.

• 7 years from the date your original return was due (not including extensions).

• 2 years from the date you paid the tax.

If the claim is for a partly worthless bad debt, you must file the claim by the later of the following dates.

• 3 years from the date you filed your original return.

• 2 years from the date you paid the tax.

You may have longer to file the claim if you were unable to manage your financial affairs due to a physical or mental impairment. Such an impairment requires proof of existence.

For details and more information about filing a claim, see Pub. 556. Use one of the following forms to file a claim. For more information, see the instructions for the applicable form.

Table 8-1. Forms Used To File a Claim

Nonaccrual-Experience Method

Generally, a person using accrual accounting isn’t required to accrue a service-provided receivable that experience shows won’t be collected if:

• The service provided is health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or

• The person’s average annual gross receipts for all previous 3‐tax‐year periods don’t exceed $31 million (indexed for inflation).

See section 448 for details and exceptions.

Recovery of a Bad Debt

If you claim a deduction for a bad debt on your income tax return and later recover (collect) all or part of it, you may have to include all or part of the recovery in gross income. The amount you include is limited to the amount you actually deducted. However, you can exclude the amount deducted that did not reduce your tax. Report the recovery as “Other income” on the appropriate business form or schedule.

See Recoveries in Pub. 525 for more information.

NOL carryover.

If a bad debt deduction increases an NOL carryover that has not expired before the beginning of the tax year in which the recovery takes place, you treat the deduction as having reduced your tax. A bad debt deduction that contributes to an NOL helps lower taxes in the year to which you carry the NOL. For more information about NOLs for individuals, see the Instructions for Form 172.

More information.

For more information about business bad debts, see section 166 and its regulations.

Nonbusiness Bad Debts

All other bad debts are nonbusiness bad debts and are deductible as short-term capital losses on Form 8949 and Schedule D (Form 1040). For more information on nonbusiness bad debts, see section 166 and its regulations.

Using the guidance

Keep the documents that establish the dates, amounts, and circumstances described above. References to other chapters, forms, worksheets, or earlier and later sections refer to the linked IRS publication. Check the full publication and its updates before relying on a rule for a different tax year or a situation not addressed here.

Sources and further reading

• Publication 334 (2025), Tax Guide for Small Business: Business Expenses — Bad Debts — Internal Revenue Service; 2025 edition.

The cited U.S. government text is in the public domain. Source accessed October 28, 2026. Fynoptic has organized this material for educational use and is independent of, and not endorsed by, the IRS.