What is Bad Debt Expense?
Bad debt expense is an accounts receivable that has become uncollectible, written off as a loss against income.
What Is Bad Debt Expense?
A bad debt expense occurs when you determine that money owed to you — an accounts receivable — will never be collected. You've billed a client, performed the work, followed up repeatedly, and exhausted your collection options. The debt is uncollectible. The financial hit you take is a bad debt expense. For freelancers, bad debt expense is an unfortunate but inevitable part of doing business. A client goes bankrupt, disputes a final payment and refuses to negotiate, or simply disappears. The work was done; the invoice was issued; the money isn't coming. The bad debt expense records that economic reality. The Practical Reality: The probability of collecting an invoice drops below 50% after 90 days past due and below 20% after 180 days. The longer you chase, the more you spend in time and resources for diminishing returns.
When Does an Account Become Bad Debt?
Not every overdue invoice is bad debt. The IRS distinguishes between: - Doubtful debt — May or may not be collectible; continue attempting collection - Worthless debt — No reasonable possibility of collection; can be written off as bad debt Signs that an account has become worthless: - Client declares bankruptcy or ceases operations - Client cannot be reached despite multiple documented attempts - Client explicitly refuses to pay - Client is judgment-proof (has no assets or income to attach) - Collection agency returns the account unpaid - Statute of limitations on debt collection has passed in your state
The Two Ways to Account for Bad Debt
Direct Write-Off Method (Cash Basis) When you determine a specific invoice is uncollectible, you write it off directly: - Debit: Bad Debt Expense - Credit: Accounts Receivable This is simpler but can distort income — a large write-off in one quarter can dramatically reduce that quarter's profit. Allowance Method (Accrual Basis) Rather than waiting for specific invoices to become uncollectible, you estimate in advance how much of your AR will never be collected (based on historical percentages from your AR aging report) and create an "allowance for doubtful accounts." - Each period, you estimate bad debts (e.g., 3% of AR) - Debit: Bad Debt Expense - Credit: Allowance for Doubtful Accounts When a specific invoice is written off: - Debit: Allowance for Doubtful Accounts - Credit: Accounts Receivable This spreads the impact of bad debts across periods rather than creating sudden expense spikes.
Tax Rules for Bad Debt Deductions
The Income Requirement This is the most critical rule: you can only deduct a bad debt if you previously included the amount in your income. If you're on cash basis accounting and never recorded the income because you never received payment, you cannot deduct the bad debt. If you're on accrual basis and recorded the income when billed, you can deduct the bad debt when it becomes worthless. Documentation Requirements To defend a bad debt deduction if audited, maintain: - Copies of invoices sent - Contract or scope of work documentation - Evidence of services delivered (emails, deliverables, timesheets) - Collection attempt records (emails, call logs, letters) - Any response (or lack thereof) from the debtor - Final demand letter - Collection agency report (if applicable) Ordinary vs. Capital Debt Most freelance bad debts are ordinary (from services rendered) and deductible as ordinary income/expense. Bad debts related to securities (e.g., loans to a company in which you hold stock) may be treated as capital losses with different rules.
Recovery of Bad Debt
Sometimes a client who stiffed you years ago suddenly pays. When you receive that recovered amount: - Record it as income (bad debt recovery) - This is especially important if you took a deduction in a prior year Many freelancers don't realize they should report recovered bad debts — but the IRS expects it.
Preventing Bad Debt
The best bad debt strategy is prevention: 1. Vet clients — Check references, look for red flags before taking large projects 2. Require deposits — 25-50% upfront reduces exposure significantly 3. Set clear payment terms — Net 15, not Net 90 4. Invoice immediately — The faster you invoice, the faster you can follow up 5. Stop work on delinquent accounts — If a client is 60+ days behind, pause the project until payment is resolved
Bottom Line
Bad debt expense is the cost of doing business on credit — even when you don't explicitly extend credit, the nature of freelance work means there's always a gap between delivery and payment. Understanding when to write off a debt, how to document collection efforts, and how the tax rules work protects your financial records and your tax position. Most importantly: prevent bad debt through upfront deposits and proactive follow-up rather than chasing it after the fact.