If you own a small business or operate as an independent contractor, you must sometimes deal with bad debt. In certain instances, it may be in your best interest to forgive a debt rather than pursue collection. In that case, you may need to adjust your accounting records to reflect the forgiven debt.
If you use the cash method of accounting, you do not recognize income until you’ve actually collected the money. No adjustment to the accounting general ledger is necessary for forgiven debt using the cash method of accounting; however, you should remove the debt from your list of accounts receivable so that you do not pursue further collection.
If you use the accrual method of accounting, you recognized the income on your accounting general ledger when you billed the client. To record the forgiveness of debt, create an account in the expense section of the accounting general ledger called “Forgiveness of Debt.” Record an increase to the Forgiveness of Debt account for the entire amount of forgiven debt. Record a decrease to the Accounts Receivable account for the entire amount of the forgiven debt. Remember to remove the client and the forgiven debt from your list of outstanding accounts receivable.
If you use the cash method of accounting, you receive no tax benefit from forgiving the debt because you never claimed the income from the transaction. If you use the accrual method of accounting, the forgiven debt offsets income claimed and reduces net income on your tax return.
If you are in the business of lending money and the forgiven debt was for a loan, you must file a Form 1099-C with the Internal Revenue Service to report the forgiveness of debt and issue a copy of the form to the customer whose debt was forgiven. The customer must report the debt as ordinary income on his personal tax filing and pay federal income tax on the forgiven amount.