Accrual vs. cash basis
Accrual basis: You recorded the income when you invoiced the client. If they don't pay, you deduct the bad debt to offset that previously reported income. This is a legitimate business deduction on Schedule C.
Cash basis: You only record income when you receive payment. If a client doesn't pay, you never had income to begin with — so there's nothing to deduct. You lost time, not money (in tax terms).
Most small businesses use cash basis accounting, which means bad debt deductions are rare for freelancers and sole proprietors.
When is a debt "bad"?
You must be able to show that the debt is genuinely uncollectible. The IRS expects you to have made reasonable efforts to collect:
- Sent multiple follow-up invoices
- Made phone calls or sent emails
- Sent a formal demand letter
- Considered or attempted a collection agency
You don't need to sue the client, but you need to demonstrate you tried.
Partially bad debts
If a client pays part of what they owe and you believe the rest is uncollectible, you can deduct just the uncollectible portion. For example, if a client owed $5,000 and paid $3,000, you can deduct the remaining $2,000 as bad debt.
You're a consultant using accrual accounting. You invoiced a client $8,000 for work completed in March. By December, after multiple collection attempts, the client has gone out of business.
Bad debt deduction: $8,000 on Schedule C
If you were on cash basis: $0 deduction (you never recorded the income)
See IRS Publication 535, Chapter 10 (Business Bad Debts). Business bad debts are deducted on Schedule C as an ordinary loss. Non-business bad debts (personal loans) are treated as short-term capital losses on Schedule D.
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