# 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.

Source: https://lopifi.com/learn/bad-debt-allowance-vs-direct-write-off/bad-debt-tax-deduction
Part of: Lopifi — US GAAP books on autopilot, checked by a CPA (https://lopifi.com)

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**When can a business deduct bad debt on its tax return?** 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Revenue Code deducts a business bad debt in the year a specific debt becomes worthless, and the reserve method was repealed in 1986.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](https://lopifi.com/md/glossary/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.

> “There shall be allowed as a deduction any debt which becomes worthless within the taxable year.”

— [26 U.S.C. §166(a)(1), (c)](https://www.law.cornell.edu/uscode/text/26/166), Bad debts are deducted when they become worthless; the reserve method is repealed

> “If you use an accrual method of accounting, you normally report income as you earn it. You can take a bad debt deduction for an uncollectible receivable if you have included the uncollectible amount in income.”

— [IRS Pub. 334 (2025), ch. 8, Bad Debts](https://www.irs.gov/publications/p334), An accrual-method business deducts a bad debt it already reported as income

The difference between the book expense and the tax deduction is a [temporary difference](https://lopifi.com/md/glossary/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](https://lopifi.com/md/glossary/deferred-tax-asset) measures.

> “Enter the total debts that became worthless in whole or in part during the tax year.”

— [Instructions for Form 1120 (2025), Line 15](https://www.irs.gov/instructions/i1120), A corporation deducts the debts that became worthless in the year

## Where this page's rules come from

- [26 U.S.C. §166(a)(1), (c)](https://www.law.cornell.edu/uscode/text/26/166) — Bad debts are deducted when they become worthless; the reserve method is repealed (statute)
- [IRS Pub. 334 (2025), ch. 8, Bad Debts](https://www.irs.gov/publications/p334) — An accrual-method business deducts a bad debt it already reported as income (irs)
- [Instructions for Form 1120 (2025), Line 15](https://www.irs.gov/instructions/i1120) — A corporation deducts the debts that became worthless in the year (irs)

## Read further

- https://lopifi.com/md/startups/bad-debt-and-write-offs
- https://lopifi.com/md/startups/form-1120-what-to-give-your-tax-preparer

- **Track:** [Accounts receivable](https://lopifi.com/md/learn/ar)
- **Part of:** [Bad debt: the allowance, the write-off and the tax return](https://lopifi.com/md/learn/bad-debt-allowance-vs-direct-write-off) — 5 min
- **Terms taught:** [Specific charge-off method](https://lopifi.com/md/glossary/specific-charge-off-method), [Direct write-off method](https://lopifi.com/md/glossary/direct-write-off-method), [Temporary difference](https://lopifi.com/md/glossary/temporary-difference), [Deferred tax asset](https://lopifi.com/md/glossary/deferred-tax-asset)
- **Previous:** [Bad debt: the allowance, the write-off and the tax return](https://lopifi.com/md/learn/bad-debt-allowance-vs-direct-write-off)
- **Next:** [Receiving Form 1099-K: what it means, AR · Lesson 9](https://lopifi.com/md/learn/form-1099-k-explained)
- **The course:** https://lopifi.com/md/learn