Could Bad Debts Lower Your 2026 Taxes?

Few things are more frustrating for a business owner than completing the work, sending the invoice, and never getting paid. Unpaid invoices and loans can create serious cash-flow problems, but in certain situations, a business may be able to turn an uncollectible debt into a tax deduction.

However, the IRS doesn’t automatically allow a deduction simply because a customer hasn’t paid. Your accounting method, the nature of the debt, and your efforts to collect the money all matter.

Understanding the rules before year-end can help you determine whether an unpaid debt may provide valuable tax relief for 2026.

Your Accounting Method Matters

The first question is whether your business uses the cash method or accrual method of accounting.

Cash-Basis Businesses

Cash-basis businesses generally recognize income when they actually receive payment.

If a customer never pays an invoice, you generally haven’t included that unpaid amount in taxable income in the first place.

Because you weren’t taxed on the income, you generally can’t claim a bad debt deduction for the unpaid invoice.

In other words, you generally can’t deduct income that was never included in your taxable income.

Accrual-Basis Businesses

Accrual-basis businesses generally recognize income when it is earned, even if the customer hasn’t paid yet.

This creates a very different situation.

If you recognized $20,000 of revenue and paid taxes on that income, but the customer ultimately never pays, you may be able to claim a bad debt deduction if the IRS requirements are satisfied.

This deduction can help offset the income that you previously recognized.

The Debt Must Be a Bona Fide Debt

You can’t simply decide that an unpaid amount is a bad debt because you don’t think you’ll ever see the money.

The IRS generally requires the debt to be a bona fide debt, meaning there was a genuine debtor-creditor relationship and a valid expectation that the amount would be repaid.

Documentation is extremely important.

Depending on the situation, useful records may include:

• Written contracts
• Invoices
• Promissory notes
• Loan agreements
• Payment records
• Correspondence with the customer
• Documentation showing the terms of repayment

The stronger your documentation, the easier it is to demonstrate that the debt was legitimate.

You Must Make a Reasonable Effort to Collect

Another important requirement is demonstrating that you actually tried to collect the money.

Simply deciding that an invoice is uncollectible generally isn’t enough.

Your collection efforts might include:

• Sending payment reminders
• Sending formal collection letters
• Contacting the customer about overdue balances
• Offering a payment plan
• Using a collection agency
• Consulting an attorney
• Documenting the customer’s bankruptcy or insolvency
• Maintaining records of communications and collection attempts

You don’t necessarily have to file a lawsuit in every situation.

For example, if a customer has filed for bankruptcy and there is little realistic possibility of recovering the debt, pursuing expensive litigation may not make economic sense. However, you should maintain documentation explaining why the debt became uncollectible and what steps you took.

Business Bad Debt vs. Nonbusiness Bad Debt

One of the most important distinctions is whether the debt is considered a business bad debt or a nonbusiness bad debt.

Business Bad Debt

A business bad debt generally arises from your business activities.

Examples might include:

• Unpaid customer accounts
• Loans made in connection with your business
• Certain business-related guarantees
• Debts arising from transactions directly connected to your trade or business

When properly deductible, a business bad debt may generally be treated as an ordinary deduction, subject to the applicable tax rules.

Nonbusiness Bad Debt

Nonbusiness bad debts are generally debts that aren’t connected to your trade or business.

For example, suppose you personally loan money to a friend and the friend never repays you.

That may be treated differently from a loan made directly in connection with your business.

A qualifying nonbusiness bad debt is generally treated as a short-term capital loss rather than an ordinary business deduction.

This distinction can significantly affect how much tax benefit you actually receive.

The Mixed-Purpose Trap

Things can become complicated when business and personal relationships overlap.

Imagine you guarantee a loan for a longtime customer who is also a close personal friend. The customer defaults, and you are forced to cover the debt.

Can you claim the loss as a business bad debt?

Not necessarily.

The IRS may examine your dominant motivation for making the guarantee or loan.

Was the primary reason to protect or advance your business interests? Or were you primarily helping a friend or family member?

The answer can affect whether the debt is treated as business or nonbusiness.

This is why documenting the business purpose behind a loan or guarantee is so important.

Example Scenario

Suppose your accrual-basis business provided $30,000 of services to a customer during 2026.

You properly recognized the $30,000 as revenue even though the customer failed to pay the invoice.

Over the following months, you:

• Sent multiple payment notices
• Contacted the customer about the outstanding balance
• Offered a payment plan
• Sent a formal collection letter
• Documented the customer’s financial difficulties

Eventually, you determine that the debt is genuinely uncollectible.

If the applicable IRS requirements are satisfied, your business may be able to claim a bad debt deduction for the amount that became worthless.

The result could reduce your taxable income and help offset the tax impact of income you previously recognized but never actually collected.

What About Debts That Are Only Partially Uncollectible?

Not every bad debt situation is an all-or-nothing decision.

A customer may pay part of an invoice but leave the remaining balance unpaid. In other situations, a borrower may agree to a reduced settlement amount.

The tax treatment can depend on the specific facts, the type of debt, and when the debt becomes partially or completely worthless.

This is another reason to review aging receivables before the end of the tax year rather than simply writing off old balances without documentation.

Why Year-End Planning Matters

As 2026 comes to a close, businesses with aging receivables should take a closer look at outstanding debts.

Consider reviewing:

• Which invoices remain unpaid
• How long each balance has been outstanding
• Whether the income was previously recognized
• Whether the debt is business-related
• What collection efforts have been made
• Whether the debt has become partially or completely worthless
• Whether adequate documentation exists

Proper documentation can make the difference between a legitimate deduction and a deduction the IRS challenges.

Conclusion

Unpaid invoices and business loans can be painful for any business owner, but certain uncollectible debts may provide valuable tax relief.

The key is understanding the difference between cash and accrual accounting, establishing that the debt is bona fide, documenting reasonable collection efforts, and determining whether the debt qualifies as a business or nonbusiness bad debt.

Don’t simply write off an old receivable and assume the IRS will accept the deduction.

If you have aging receivables or potentially worthless business debts, contact Guerrero CPA at 210-490-7100. Our team can review your accounting method, evaluate your outstanding debts, examine your collection documentation, and help determine whether you may qualify for a valuable bad debt deduction on your 2026 tax return.