What is a charge-off and does it affect my business taxes?
What is a charge-off and how does it affect your business taxes?
Short answer
A charge-off is an accounting entry that moves an uncollectable invoice from accounts receivable to bad debt expense. For accrual-basis businesses, this typically creates a tax deduction in the year the debt becomes worthless. Cash-basis businesses generally cannot deduct bad debts. The mechanics vary by your accounting method — consult your accountant before treating this as a deduction.
A charge-off does not mean you forgive the debt or give up the right to collect it. It is purely an accounting move: you stop carrying the invoice as an asset on your balance sheet and record it instead as bad debt expense. You can still attempt collection after charging off — if you eventually recover the amount, you record the income at that time.
For tax purposes, whether a charge-off creates a deduction depends on your accounting method. Accrual-basis businesses recognize revenue when earned, so unpaid invoices are already in taxable income. When those invoices become worthless, the IRS allows a bad debt deduction that offsets the income already recorded. Cash-basis businesses only recognize income when actually received, so there is no previously-taxed income to offset.
The IRS has specific requirements for what makes a debt 'worthless.' You need to document that you made reasonable collection efforts and that there is no reasonable expectation of recovery. A debt is not worthless just because it is late — a customer who is slow-paying is not the same as one who has gone out of business or explicitly refused to pay after collection efforts.
Timing matters. A bad debt deduction generally belongs in the tax year the debt became worthless, not the year the invoice was issued. If you charge off invoices years after they went unpaid, amending prior returns may be required. This is a question for your accountant. Not legal or tax advice.