The tax deduction for bad debts
Why the federal return ignores the allowance, deducts a debt only in the year it becomes worthless, and where the book-tax difference shows up.
Federal tax doesn't allow a reserve. The Internal Revenue Code deducts a business bad debt in the year a specific debt becomes worthless, and the reserve method was repealed in 1986. That's the specific charge-off method. For an accrual-method business the debt must already have been included in income, which Northwind's invoices were when issued. So Northwind's $1,455 of 2026 book expense isn't deductible in 2026: no debt became worthless that year. Kestrel's $2,400 is deductible in 2027, the year it did.
The difference between the book expense and the tax deduction is a temporary difference. It shows up where Form 1120 reconciles book income to taxable income (Schedule M-1, which the smallest corporations may skip), and it's the kind of item a deferred tax asset measures.
Where this lesson's rules come from
The sources behind this lesson's requirements, by kind. Anything marked as a convention is ours, not the rule-maker's.
- Federal statute
- 26 U.S.C. §166(a)(1), (c) (opens in a new tab)Bad debts are deducted when they become worthless; the reserve method is repealedFree to read
- IRS guidance
- IRS Pub. 334 (2025), ch. 8, Bad Debts (opens in a new tab)An accrual-method business deducts a bad debt it already reported as incomeFree to read
- Instructions for Form 1120 (2025), Line 15 (opens in a new tab)A corporation deducts the debts that became worthless in the yearFree to read
The words this page teaches
Each links to its glossary definition, which also names the authority behind it and the components that render it.
- Specific charge-off methodThe federal income tax method for business bad debts: a deduction for a specific debt in the year it becomes wholly or partly worthless, never for an estimated reserve — and, for an accrual-method business, only for an amount already included in income
- Direct write-off methodCharging a receivable to bad debt expense only when it is judged uncollectible, with no allowance. Not GAAP where expected credit losses are material; the federal tax rule works the same way (specific charge-off)
- Temporary differenceA difference between an asset or liability's tax basis and its book carrying amount that will reverse in future years — the source of deferred taxes
- Deferred tax assetFuture tax savings from deductible temporary differences and carryforwards, measured at enacted rates
See also
- Bad debt and write-offs: allowance vs direct methodHow to book a customer who won’t pay: the GAAP allowance under ASC 326, the direct write-off the IRS requires, and what to do if the money comes back.
- Form 1120: what to give your tax preparer, and whenWhat a startup hands its tax preparer for Form 1120: closed books, a balance sheet that ties to Schedule L, book-to-tax items, ownership and 1099s.