Bad Debt Expense: How to Record It and When It's Deductible

Bad debt expense is the part of your accounts receivable you have decided you will not collect. A customer bought on credit, the invoice went unpaid, and at some point you stop counting on the money and record the loss. On the books it is an expense that reduces your profit and writes the receivable down toward zero. The question that trips up most self-employed readers is not how to book it, but whether the tax code lets you deduct it, and that answer turns entirely on your accounting method. Here is what bad debt expense means, the two ways to record it, and when the IRS lets you write it off.

What is bad debt expense?

Bad debt expense is what a business records when a receivable becomes uncollectible. You sold goods or services on credit, booked the sale, and created an account receivable for the money owed. When the customer cannot or will not pay, that receivable is worth less than its face value, and the shortfall becomes an expense.

The Corporate Finance Institute describes bad debt expense as "the way businesses account for a receivable account that will not be paid" (Corporate Finance Institute). It shows up on the income statement as an operating expense and pulls your net income down by the amount you write off.

Some level of bad debt is normal for any business that extends credit. Across the US, 47% of small businesses reported that a portion of their invoices were overdue by more than 30 days, and 56% said they were owed money on unpaid invoices, averaging $17,500 per business (Intuit QuickBooks 2025 US Small Business Late Payments Report). Not every overdue invoice becomes a bad debt, but any business that invoices on net terms risks some going unpaid.

The two methods for recording bad debt

There are two accepted ways to move an uncollectible receivable off your books: the direct write-off method and the allowance method. They reach a similar place, but they hit your financial statements at different times.

Direct write-off method

Under the direct write-off method, you wait until a specific invoice is clearly uncollectible, then record the loss for that exact amount. You debit bad debt expense and credit accounts receivable:

The appeal is simplicity, and it matches what the IRS wants on a tax return. The weakness is timing: the write-off often lands in a later period than the sale it relates to, so it "can result in misstating the income between reporting periods" (Corporate Finance Institute). A sale booked in December can produce a bad-debt hit the following June. For that reason, GAAP allows the direct write-off method only for immaterial amounts.

Allowance method

The allowance method estimates uncollectible accounts in advance, in the same period as the sales that created them. This is the method GAAP requires for financial reporting, because it matches the expense to the revenue it relates to.

You set up a contra-asset account called the allowance for doubtful accounts, which sits against accounts receivable and lowers its net value. Recording the estimate takes one entry:

Later, when a specific customer's $1,500 invoice is confirmed dead, you write it off against the allowance you already built. That second entry does not touch bad debt expense again:

The expense was recognized when you made the estimate, so writing off the individual account only reshuffles the balance sheet. Your income statement already absorbed the hit in the right period.

How to estimate the allowance

The allowance method needs an estimate, and there are two common ways to build one.

The percentage-of-sales method applies a historical rate to the period's credit sales. If Meridian Design, an accrual-basis studio, books $200,000 of credit sales in 2026 and history says about 2% go bad, the estimate is $200,000 × 2% = $4,000 of bad debt expense.

The accounts receivable aging method looks at what is still outstanding and weights it by how overdue it is. Older receivables are far less likely to be collected, so each age band gets its own rate. Say Meridian ends the year with $50,000 in receivables:

The aging schedule says the allowance for doubtful accounts should hold $2,450. Aging is a balance-sheet target, so you adjust to it. If the allowance already carries a $400 credit balance from last year, you record only the difference: $2,450 − $400 = $2,050 of bad debt expense this period. The same tracking improves your accounts receivable turnover: the sooner you see an account slide into the 90-day bucket, the sooner you can chase it.

Can you deduct bad debt on your taxes?

This is where the bookkeeping concept and the tax rule split apart. Whether a bad debt is deductible depends on whether you ever counted the money as income.

The IRS states the condition directly: to claim a bad debt deduction, "you must have previously included the amount in your income or loaned out your cash." Cash-method taxpayers "can't deduct bad debts for unpaid salaries, wages, rents, fees, interests, dividends, and similar items of taxable income" (IRS Topic No. 453, Bad Debt Deduction).

Most sole proprietors and single-member LLCs file Schedule C on the cash method, and that method decides the outcome. Suppose a cash-basis freelancer invoices a client $3,000, delivers the work, and the invoice goes unpaid. On the cash method, that $3,000 was not reported as income, because income is recognized only when cash arrives. There is no deduction, because there is nothing to deduct. The freelancer is out the work, but the tax return has no $3,000 of income to reverse.

An accrual-basis business gets the opposite result. It already reported the $3,000 as income when it earned the sale, so when the debt goes worthless it deducts $3,000 as a business bad debt, canceling the income it was taxed on. The Schedule C instructions draw the line in one sentence: "If you use the accrual method of accounting, you can deduct business bad debts" (2025 Instructions for Schedule C). On the form, a business bad debt is reported as an "other expense" in Part V of Schedule C, which carries to line 27b.

The statute behind this is Internal Revenue Code Section 166, which allows a deduction for "any debt which becomes worthless within the taxable year," meaning there is no reasonable expectation of repayment (IRS Topic No. 453). A business can also write off a partially worthless business debt; that option does not exist for personal debts.

One more distinction matters. A loan made outside your business, such as a personal loan to a friend that is not repaid, is a nonbusiness bad debt. Section 166(d) sends it down a different path: a short-term capital loss on Form 8949, deductible only if the debt is totally worthless. So settle the business-or-nonbusiness question first.

Common misconceptions

"Any unpaid invoice is a tax write-off." Only if you are on the accrual method. If you file Schedule C on the cash method, an unpaid invoice was not counted as income, so there is no deduction when it goes bad. You feel the loss in your bank account, not on your tax return.

"Bad debt expense and the write-off are the same entry." Under the allowance method they are two separate events. You record the expense when you estimate the allowance, and the later write-off of a specific account only moves the balance from the allowance to accounts receivable. Booking bad debt expense a second time when you write the account off would double-count the loss.

"The allowance for doubtful accounts is a liability." It is a contra-asset. It lives on the asset side of the balance sheet, directly under accounts receivable, and reduces receivables to the net amount you realistically expect to collect. It is not something you owe.

How SparkReceipt fits

SparkReceipt does not create invoices or run an accounts receivable ledger, so the bad debt entry and the aging schedule live in your accounting software. What it keeps accurate is the record underneath the numbers: its income tracker captures the payments that land, and the AI reads each receipt and invoice to pull the vendor, amount, date, and tax, so the income you recognize and the expenses you deduct are both documented.

For a cash-basis freelancer, that clean record makes the bad-debt question moot: you were taxed only on money you received, so an unpaid invoice did not inflate your income. For an accrual-basis business, the same records support the income figure a bad-debt deduction later reverses. See pricing for plan details. Get Started and keep this year's income and expenses documented before tax time.

Frequently asked questions

What is the difference between the direct write-off and allowance methods? The direct write-off method records the loss only when a specific invoice is confirmed uncollectible, which can push the expense into a later period than the sale. The allowance method estimates uncollectible accounts in advance and matches the expense to the same period as the sales, which is why GAAP requires it for financial reporting.

Is the allowance for doubtful accounts an asset or a liability? Neither exactly. It is a contra-asset account that sits against accounts receivable and lowers its net value on the balance sheet, showing the amount you realistically expect to collect.

Can a sole proprietor deduct an unpaid invoice? Usually not. Most sole proprietors file Schedule C on the cash method, where income is counted only when received. Because an unpaid invoice was not reported as income, there is nothing to deduct. Only accrual-method businesses, which already reported the sale as income, can deduct it as a business bad debt.

When does a debt become deductible? In the year it becomes worthless, meaning there is no reasonable expectation of repayment. The IRS expects you to show you took reasonable steps to collect first.

Key takeaways

• Bad debt expense is the portion of accounts receivable a business no longer expects to collect; it reduces net income and writes the receivable down.
• The direct write-off method records the loss when a specific account is confirmed uncollectible; the allowance method estimates it in advance and is the method GAAP requires.
• The allowance for doubtful accounts is a contra-asset that reduces receivables to their net collectible value, and writing off a specific account under the allowance method does not create a second expense.
• Estimating the allowance uses either a percentage of credit sales or an accounts receivable aging schedule, where older balances carry higher uncollectible rates.
• The tax deduction depends on your accounting method: cash-basis filers cannot deduct an unpaid invoice because it was not in income, while accrual-basis filers deduct it as a business bad debt on Schedule C under Section 166.
• A worthless personal loan is a nonbusiness bad debt, deductible only as a short-term capital loss on Form 8949 and only if totally worthless.