Choosing The Way To Write Off Bad Debts

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Bad debts can drown almost any business. If you don't collect an account receivable, a tax write-off is the next best thing -- and the sooner the better. Essentially, there are two methods of deducting bad business debts. They may be deducted when an account becomes totally or partially worthless, under the direct write-off method. Or you may establish a reserve fund, under the so-called reserve method.

Either method can be elected when you file your tax return. But the reserve method has strong advantages since it allows you to anticipate your bad-debt deduction. For example, assume your accounts receivable at the end of the year are $250,000. Also assume your previous experience shows that about 2% of your accounts receivable will be written off as uncollectible at year-end. If you elected the reserve method, you could set up a reserve of $5,000 (2% of $250,000). This would give you an immediate $5,000 deduction even though you can't identify at that time the accounts that are likely to go bad.

What if you are on the direct write-off method and want to switch to the reserve method? It's easy to get permission from the Internal Revenue Service. You just file Form 3115 within 180 days from the beginning of the taxable year.