Just because you do everything you can to please your customers is no guarantee that you’ll be paid for your efforts. According to the Commercial Collection Agency Association, after 30 days past due, the chances of being paid drop to 89.9%; after six months, there’s only a 52.1% chance of being paid. When you experience nonpayment, how do you handle this unfortunate situation for tax purposes? The simple answer: You can only hope that the tax treatment of the bad debt won’t add further insult to your economic injury.
There’s bad news for you if you report your income and expenses on the cash method of accounting. You cannot enjoy any tax relief for unpaid invoices related to services. You cannot deduct the unpaid amount for your time and effort. For example, a consultant on the cash method of accounting completes an engagement and sends an invoice for $2,500. The client never pays the bill. The consultant cannot deduct anything; the $2,500 in fees not paid is an economic loss of time and effort but is not a taxable write-off.
Of course, related costs to performing services are deductible in the usual way. Thus, materials and supplies used in the course of work, wages to employees, and other expenses are deductible as they would be in the same way as if payment had been received.
Small-inventory based businesses that use the cash method of accounting treat inventory items as materials and supplies. If you don’t get paid for a sale, you lose your profit—with no tax write-off—but you’ve probably already deducted what you paid for the items when you bought them.
If you report income and expenses on the accrual method of accounting, which is the common method for inventory-based businesses as well as larger service-based businesses, unpaid invoices can be deducted when they become uncollectible. This effectively offsets the income that has already been reported. For example, in the example above if the consultant had been using the accrual method of accounting, she would have accrued the income when the work was completed and the invoice sent. Thus, when it becomes clear that some or all of the bill will never be paid, she can deduct the unpaid amount to zero out the income she already accrued.
Unpaid receivables are technically called business bad debts, which arise from operating a business. They are deductible as ordinary losses. There are two ways to do this:
- Specific charge-off method. When receivables become partially or totally worthless, you can deduct the unpaid amount. This is the amount you charge off your books, meaning you note in your accounts that the amount has become uncollectible. If you take a partial write-off and the amount later becomes wholly worthless in a later year, you can then deduct the balance in that later year. You cannot take any deduction for estimated or anticipated losses; only actual losses. This is so even if a business uses the allowance method to estimate bad debts (“doubtful collections”) for accounting purposes under generally accepted accounting principles (GAAP).
- Nonaccrual-experience method. If your business earns its money from performing services in the fields of accounting, actuarial sciences, architecture, consulting, engineering, health, law, or the performing arts, you don’t accrue income that you don’t expect to receive, based on your experience. In this way, you don’t accrue income, so you don’t have to deduct uncollected receivables. This option is limited to businesses with average annual gross receipts under $5 million for the three prior years (e.g., average annual gross receipts for 2014 is based on 2012, 2013, and 2014).
Tax strategies for deducting unpaid receivables
You don’t have to make a determination about whether amounts owed to you are partially or fully worthless until the end of the year. Make it your annual practice to review the status of unpaid receivables at the end of the year. Technically, you have seven years to determine a bad debt and file an amended return reflecting the loss.
Once your company’s efforts to collect prove fruitless, it may be time to turn to a collection agency. This will allow you to nail down a partial write-off. When you hand over uncollected invoices to an agency, you agree to pay a certain amount to the agency. You can treat the fee as fixing a partial write-off of your receivable immediately.
For example, a $1,000 receivable is way past due, so in 2014 you engage a collection agency to recoup whatever possible. The agency’s fee is 30% of what it collects. You can deduct $300 (30% of $1,000) in 2014 because you’re certain that even if the agency collects 100% of what is owed you’ll never see $300. If and when the agency collects on the receivable, you can then determine the actual extent your loss. You’ll file an amended return for the year of the unpaid invoice, and the IRS will issue a refund for tax related to the excess over what you already deducted. Just make sure you have good records to support your tax positions.
Work with a knowledgeable tax advisor to make sure you’re handling receivables properly for tax purposes. Better yet, use sound collection policies to minimize or avoid having any unpaid receivables.
About the Author:
Barbara Weltman is an attorney, a prolific author with such titles as J.K. Lasser’s Small Business Taxes and J.K. Lasser’s Guide to Self-Employment, and a trusted professional advocate for small businesses and entrepreneurs. She is a guest columnist for The Wall Street Journal and U.S. News and World Reports and contributes regularly to SBA.gov and SmallBizTrends.com. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com and a radio host. Follow her on Twitter @BarbaraWeltman.