In an ideal world, every customer or client of your small business would pay their bills. But in the real world, you will sometimes end up with a client who cannot or will not pay their invoice. Can you use this nonpayment on your income taxes to lower your tax bill? When and how? And what if the customer finally pays up? Here are the answers to a few questions.
What Is a Business Bad Debt?
The IRS permits businesses and individuals to deduct worthless debts as a business expense when these debts occur in the regular course of their business. So it doesn't include loaning your sibling money for rent.
The vast majority of business bad debts are generally credit extended to customers who don't end up paying their invoices. However, it can also include things like debts of an insolvent partner, outright loans to vendors or other businesses, debts you remain responsible for after selling a business, or personal guarantees on loans.
When and How Can You Claim It?
A debt becomes a bad debt in the tax year in which it's fundamentally worthless — when you have no reasonable hope of receiving the outstanding balance. Some businesses write off individual bad debts, such as unpaid invoices, as they occur. Other businesses calculate the average amount that becomes worthless each year and use this estimation for accounting and tax purposes (known as the nonaccrual experience method).
Businesses with cash-based accounting, though, may not be able to deduct bad debts. The reason is that income is not recognized (and reported on tax forms) until it is received. So if you never received this income, you can't deduct the worthless debt as an expense.
What If Someone Pays Later On?
In the rare circumstance where the client eventually does pay their bill — such as a client who wants to purchase your services again — the business will need to reverse the original deduction. In general, this is done by declaring the payment as 'Other Income' on IRS forms. However, the amount you must declare as income is usually limited to the amount you deducted earlier or which lowered your taxes.
Where Should You Start?
Properly tracking your worthless debt and knowing how to use it on your taxes is vital to avoid overpaying. Even if you do track such debts, could you benefit from using the nonaccrual experience method? And how should you erase bad debts from your books if they are paid? Start by learning more about this important, but sometimes confusing, accounting issue. Meet with an accounting service in your state today to learn more.