Can You Write Off Those Uncollectible Invoices as Bad Debt?

As a small business owner you will, more than likely, encounter a customer who never pays his bill. It would be wonderful if that were not true, but if you talk with your small business owning peers, you will find everyone has a story to tell. But when it happens to you – at least for the first time – you might be a little baffled. NOW what do you do?

When bad debt rears its ugly head, be sure you are handling it properly on your books and for tax purposes. It’s costly if you don’t!Hopefully you have taken steps to try to collect the payment(s) owed to you and, for this article, we are going to assume that is true. Sometimes there is a disagreement over products or services provided and invoices are held hostage until the disagreement is resolved. But in other cases, the bills simply are never paid or the customer’s business enters into bankruptcy or closes. For now, we are going to assume you come to the conclusion that you will never be paid for the outstanding invoices.

Bad Debt is more than aggravation, it’s an accounting problem

After the shock wears off, you realize that you now have a bookkeeping, or accounting problem. You potentially have a BAD DEBT and you’ve heard that you can write-off bad debts on your taxes. Is that really true?

According to the IRS, there are two types of bad debts:

  1. Business
  2. Non-business

The IRS says a business bad debt is …

“a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless.”

They then go on to say that you CAN deduct it on Form 1040, Schedule C or on your applicable business income tax return. BUT in a little aside as they list examples of bad debts, their directive says (if previously included in income)

That little aside speaks volumes for the small business owner who is not well-versed in bookkeeping or accounting because that means your books must be on an ACRUAL BASIS in order to “write off” the bad debt.

How is a write-off handled on the books and for accounting purposes?

The reason you can write off bad debt when you are working on an accrual basis is because all receipts, whether actually received or not, are included as income. So, you are paying taxes on that income (yes, whether you have actually received it or not) as the invoices are put on the books. That’s why, when the income never comes in, you can reduce your tax liability and write off the bad debt.

Now, I want to be clear here, there are different ways that are generally acceptable accounting practices (GAAP) for accomplishing this on your books and for your taxes. How you handle writing off bad debt depends on how you are handling it on your books and reporting it in your tax returns. Consistency is important here. This is a conversation you need to have with your bookkeeper and accountant.

Most small businesses are handling their books and tax reporting on a cash basis. That means that you report cash receipts as your income, not what has been invoiced and is still a receivable.

When your books and taxes are handled on a cash basis, there is no “write off” applicable. Sorry. Uninformed small business owners doing their own taxes might make the mistake of trying to write it off by deducting it from actual received income. It doesn’t work that way, but might seem logical at the time.

Of course, if your returns and accounts are audited, the truth will come out and you will be held liable for the resulting fines and penalties due to your lack of knowledge.

Financial questions always come up for the small business owner

You (probably) didn’t open your business to take care of the financial books and tax returns. Seldom do I hear that entrepreneurs are excited about that end of business ownership. But the truth is that you do have to follow GAAP because the IRS doesn’t care that you don’t understand the rules. They pretty much feel you are a business professional and are handling your business professionally.

That does not mean YOU have to know all the rules of GAAP or tax planning and return preparation. It DOES mean you have to have someone on your side who does. It’s just like the work we do for small business owners in payroll processing and payroll tax reporting and payment. We know the rules and keep our clients in compliance with following them. They rely on us to do that.

The same must hold true for your bookkeeping and accounting. And that is the reason we also provide bookkeeping services for our clients. Mistakes do happen, but many very costly mistakes can be avoided if you outsource your highly-regulated aspects of business to professional hands who know how to handle them.

It’s true that a successful small business owner doesn’t do it alone. Nope. A successful small business owner has a bevy of professionals supporting the work done and the business overall. The Payroll Department has been one of those professional support services to owners for many years in payroll processing, and now in bookkeeping, too.

We want our clients to be successful and do our part to help them achieve success. Give the owner of our company, Teresa Ray, a call today at 317-852-2568 to see how we can support you in your business.


-Elaine of The Payroll Department Blog Team

Posted in: Bookkeeping and Accounting, Operating a Small Business

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