Can Our Law Firm Write Off Bad Debts?

It’s an unfortunate reality for many firms: sometimes clients don’t pay their bills. You’ve provided the service, sent the invoices, followed up, and still the payment never arrives. At that point, it’s time to start thinking about writing off bad debt.  

You may be able to write off or take a deduction for debts as long as they meet specific requirements. Understanding what qualifies as bad debt and how to properly handle it on your books can help protect your firm’s finances and prevent you from being taxed on income you never actually received. 

What is Bad Debt?  

Bad debt is money you’ve earned and billed to a client, but haven’t been able to collect and are unlikely to recover. If a client simply refuses or is unable to pay you for legal services rendered, the amount they owe becomes bad debt. 

So, what does “write off bad debt” mean? Writing off bad debt allows your firm to remove the unpaid amount from accounts receivable. Usually, you’ll be able to claim a deduction for the unpaid balance at tax time.  

While it doesn’t erase the frustration of unpaid work, the ability to write this debt off does keep you from taking a total financial loss. 

Requirements to Write Off Bad Debt

To prevent companies from abusing write-offs, the IRS sets clear conditions for when it’s allowed. Acceptable write-off debt must meet the following four criteria.  

Bona Fide Debt Owed  

First and foremost, the debt must be a legitimate, bona fide debt owed to you to be considered bad debt. You’ll need to have documented proof of services rendered, the payment agreed upon, and failure on the client’s part to deliver payment.  

Written proof of the debt provides the strongest documentation, but oral agreements are possibly enforceable.  

Basis in Debt  

You also need to demonstrate a basis in the debt by including the amount the client owed you in your firm’s gross income for the year.  

This important step indicates that your firm treated the money as taxable income for that tax year and that the debt balance was not intended as a gift.  

Business Debt Only 

Only business-related debt qualifies for tax deduction. Personal debts can’t be deducted or written off. The IRS typically considers them nondeductible gifts unless there is substantial documentation that proves otherwise.  

For law firms, this means the unpaid bill must directly connect to legal services rendered. 

Worthless Debt 

Finally, the bad debt needs to be considered at least partially worthless. A debt is considered worthless if there’s no reasonable chance of being able to recover it despite your best efforts. Recovery attempts can include: 

• Issuing written payment reminders by mail, email, or text message 

• Making payment reminder phone calls 

• Engaging a collection agency for recovery 

If there is still a possibility of recovery or the balance is simply tied up in a billing dispute, you may not be able to write the debt off.  You must claim a bad debt tax deduction in the same year the debt becomes worthless. 

How to Demonstrate that Your Debt is Worthless  

Multiple factors will affect the market rate you set: paralegal experience, education level, and your You don’t have to send your client’s account to collections or file a lawsuit against them to prove that a debt is worthless. In fact, you don’t even need to wait until the total amount of the debt is due. 

You do, however, need to show that you’ve taken reasonable measures to collect the debt. It’s also sufficient to demonstrate that any future efforts at collection would be futile.  

This might include:  

• Repeated and unsuccessful attempts to collect  

• Proof that the debtor filed for bankruptcy or has been through bankruptcy to have all or part of the debt forgiven  

• The debtor has gone out of business, died, or disappeared 

With no reasonably possibility of collecting a bad debt that meets the 4 criteria above, you can safely consider it worthless and acceptable for write-off.  

The Importance of Documentation When Writing Off Bad Debt 

As with any financial issues, documentation is critical in bad debt situations. Keep all evidence of your collection efforts related to a bad debt: unpaid invoices, copies of digital or mailed payment reminders, records of collection phone calls, credit reports, and anything that documents your genuine effort to recover the debt. 

Handling all client invoices and payments in legal billing systems makes recovering debt easier. Using these platforms keeps all client communications and payment activities stored, linked to the proper client and matter, and archived for instant retrieval when you need them.  

When to Write Off Bad Debt  

TheBad debt must be deducted or written off in the year that it becomes totally worthless. If you’re dealing with a partially worthless debt, you can deduct the unpaid portion that year or wait until the next to deduct it.   

Say your firm invoices a client $10,000 for litigation services in March. Despite repeated attempts, you’ve only collected $6,000 by December, when the client files for bankruptcy. The remaining $4,000 can now be considered worthless and uncollectible.  

The $4,000 can be written off as bad debt for that tax year to reduce your taxable income by the amount that was never received. 

How to Claim a Bad Debt Deduction on Your Taxes 

What does it mean to write off bad debt? Essentially, you report them as ordinary losses on Form 1040 on a Schedule C, F, or A. If the bad debt wasn’t deducted on your original return the year it became worthless, you can file for a credit or refund.  

If you missed filing a deduction on your return the year the debt became worthless, it may not be too late. If the bad debt is considered totally worthless, you can file a claim:  

• Seven years from the date your original return was due (excluding any filing extensions), or 

• Two years from the date you paid the tax  

For partially worthless debts, you can file a claim up to:  

• Three years from the date you filed the return, or 

Two years from the date you paid the tax rates in your area and where the paralegal’s skills and experience place them within the market range. 

What Happens If You Recover a Bad Debt? 

Sometimes a client you thought was gone for good makes an unexpected payment down the road. When that happens, the IRS requires you to treat the recovered amount as income, but only up to the amount you previously deducted. This is called the tax benefit rule. 

Using the earlier example, your firm wrote off $4,000 in unpaid fees as bad debt. If the client unexpectedly pays $2,500 this year, you’ll need to report that $2,500 as income on this year’s return. 

While it may feel frustrating to add the amount back, remember that you already benefited from the deduction in the prior year. Recoveries simply ensure your taxable income reflects the true picture of what was ultimately collected. 

Protect Your Firm from Bad Debt with CosmoLex 

Unpaid invoices are frustrating, but they don’t always have to spell financial loss. By understanding the rules of writing off bad debt, your firm can minimize the impact of nonpayment and protect your bottom line. 

The right tools make all the difference. With a legal practice management platform that integrates billing and payments, your firm has everything it needs in one place. Not only do you get clear documentation if a debt goes unpaid, but you also gain proactive featuresthat help prevent bad debt from happening in the first place, like automated payment reminders and detailed records tied to each matter.  

It’s a smarter way to safeguard your firm while building stronger, more trusting client relationships. 

See how CosmoLex helps law firms simplify billing, streamline collections, and protect against bad debt. Schedule your free demo today. 

Browse other related articles 

Learn more about non-payment, bad debt, and managing your firm’s collections with these helpful resources: 

• How Can My Law Firm Avoid Bad Debt?  

• As a Lawyer, What Can I Do If My Client Won’t Pay Their Bills?  

• What Are the Best Criminal Law Software Options That Help with Collections?