How Much Bad Debt is ‘Good’ Bad Debt?

At a time of rising inflation and interest rates, fears of a recession are persisting, and the average business owner is feeling more of a pinch than usual. More companies are likely to fall behind or default on their own financial obligations to vendors and other creditors.

It all adds up to a clear and present risk of bad debt — loans or outstanding balances that are no longer deemed recoverable. But how much bad debt is actually “good” bad debt?

The Bad News About Bad Debt

It’s called “bad” debt for a reason, and it’s naturally difficult to find a positive spin when the outcome is not receiving payment from your customer. An uncollectible account is, in theory, a worthless asset. (We’ll get to the “in theory” part below.) Failure to collect on receivables means that revenue projections have been overstated, and when cashflow slows down, that may also limit the ability of your business to pay off its own debts, operating expenses, and other payables.

Adding insult to injury, your business has allocated capital and human resources in pursuit of collecting the debt, turning the situation from bad to worse. What, then, can possibly be the good news about bad debt?

The Good News About Bad Debt

The silver lining to bad debt is found from a tax perspective. IRS Topic No. 453 Bad Debt Deduction stipulates that bad debt can be deducted on business tax returns. A business deducts its bad debts, either fully or partially, from gross income when calculating its taxable income. Tax-deductible bad debt can include loans to clients, suppliers, distributors, and employees; credit sales to customers; or business loan guarantees.

By reducing your company’s taxable income, the uncollectible account isn’t “worthless,” after all. Nevertheless, these tax implications still require a thoughtful analysis. Bad debt disrupts the ability of a business to practice accounting’s “matching principle,” which requires that expenses be matched to related revenues in the same accounting period in which a revenue transaction occurs.

Receiving a tax deduction on an uncollectible account doesn’t eliminate the expense-revenue disconnect created by the failure to collect.

Therefore, rather than simply writing off all bad debts on its tax return, a business should also use the “allowance method.” This practice estimates uncollectible accounts as a percentage of sales or total outstanding receivables, thereby reporting revenues and related expenses during any given period. These estimates can take into account the business’ amount of bad debt from previous periods, economic conditions, and the aging of receivables. Accounting professionals generally recommend that a business’ ratio of bad debt to actual write-offs should be approximately 1:1.

Avoiding Bad Debt — Even the ‘Good’ Kind

While the damage caused by bad debt can be softened through the tax benefit, bad debt is hardly a business strategy in and of itself. For instance, let’s say that an uncollectible account of $100 is written off, generating a tax deduction of approximately $30. Any way you slice it, you’ve still lost $70 from the uncollected receivable of $100!

When you fail to collect, your business isn’t growing. At the same time, your business can’t conceivably collect on every single one of its receivables. Some of the bad debt can be “good” bad debt — yet only to the point where the anticipated tax deduction sufficiently offsets revenue loss. As the full picture is complex and looks different for each business, and every situation has its unique circumstances, it’s best to consult with a tax professional to comprehensively assess how the bad debt is affecting your bottom line.

Accordingly, just like individuals can take steps to boost their immune system in the face of viruses and infections, businesses should proactively prevent (or at least try to minimize) bad debt in the first place. That can be accomplished through conducting credit checks for new customers, requiring certain percentages of credit sales to be paid up front, offering discounts for upfront cash payments and/or incentives for early payments on a payment plan’s timeline, and sending prompt and frequent invoices to the customer.

Additionally, prior to making a firm or final determination that a debt is uncollectible and therefore “bad,” remember that you can work with a commercial collection agency (like BARR Credit Services) to pursue the funds. You might not possess the staff resources to persevere in this chase. But before sending the debt to the dustbin of history and settling for a tax deduction, consider contracting with a third-party collector who can approach the situation with a fresh set of eyes and, most importantly, with their subject-matter expertise and experience in collecting on commercial accounts.

Ultimately, while some bad debt can be “good” bad debt, exhausting all feasible options for collection is the best initial course of action.