Do I get a Tax Break for the Client that Didn’t Pay?
In a word, no. During the course of your business life, this will affect just about everyone at one time or another. In good faith you enter into an agreement with a client for goods and services. You receive the sale and post it into your Accounts Receivable as Income. As time goes by 30, 60, 90, and finally 120 days have passed and no payment is received from a client. Attempts were made to discover the problem and the client has been non-responsive. After a certain period of time has passed, you involve a collections service to recover this unpaid debt and still no reply. Finally, after all has been done to recover the debt it has been determined that this will be a “Bad Debt” to your company. There are 2 types of bad debts:
- Business Bad Debt – This is a goods and services loss that was created during the course of your business with an expectation of compensation in return for the product sold.
- Non Business Bad debt – This type of losses is usually associated with short term capital gains and are sometimes offset by Income received under the same category.
We need to also consider the process of how the debt transaction was accounted for during the business cycle. Let’s review the 2 methods of accounting most commonly used by businesses:
- Accrual Method – This method is used primarily in conjunction with Accounts Receivable and Accounts Payable accounts. You allow your client to have use of a service or product in advance of payment. This allows for your company to record the sale in Accounts Receivable as Income with an expectation to pay under certain agreed terms.
- Cash Method – This method has less risk than the Accrual method since cash is paid at the time of purchase. However, checks can be returned, credit cards can have charges declined or refused, even cash can be found to be counterfeit and therefore you are faced with a loss.
Now that is has been determined that a loss has occurred, we need to determine whether or not it qualifies as a deductable bad debt. First, the debt in question must have been accounted for as Income prior to the write off. This means that you reported this as Income during the course of your business and perhaps applied sales taxes and other levies against it in your business reporting. This is usually not a problem in “Accrual “accounting method, but in the “Cash” accounting method, the burden of proof requires a little more back up.
For record keeping and back up purposes, bad debt expenses that were paid in cash, check, and credit card charges that turn out to be fraudulent payments you can use your financial institutions notification as proof. Also you should file a report with local law enforcement to show an attempt to collect from the client. The bad Debt can now be applied to your tax form under the appropriate business return.
As you can see, clients who do not pay can cause as much expense as the bad debt that was incurred.
Please review IRS Publication 535 and Publication 334 for more guidelines.