As a business owner, you may have introduced the concept of credit terms in order to increase sales of some of your high-ticket products and services. After all, the prospect of ‘buy now, pay later’ can be appealing to an interested customer.
Here’s the problem that arises when you start offering credit terms, however. You are inevitably going to end up with bad debt. Although some customers will pay off their purchases in full and on time, others will drag their feet, fall behind, and even stop making payments altogether.
What do you do when your business is dealing with bad debt when it comes time to report income to the IRS? Well, you write it off — legally, of course.
Today, I’m going to show you exactly how to do that so that you drastically improve your business’s financial position come tax season.
Can Your Bad Debt Actually Be Written Off?
First things first — can your bad debt actually be written off? Not all debt is created equal. A debt that a customer is paying back slowly or inconsistently cannot legally be written off.
In order for the debt to be written off, it needs to be considered totally or partially worthless. In other words, there needs to be little or no chance of the customer paying back that amount to you.
What Types of Bad Debt Should Be Written Off?
How much of your business’s bad debt should be written off? Simply put, you should write off any bad debt that would legally qualify for a tax deduction.
The problem with bad debt goes beyond you being unable to recover your money. As the Internal Revenue Service (IRS) considers that money taxable from the moment that you are paid, you are only increasing your business’s tax liability whenever you keep those overdue accounts open.
Of course, keeping these bad debts around can prevent your business from being as profitable as it could be, so it’s in your best interest to write them off!
3 Rules for Writing Off Your Business’s Bad Debt
While you may be eager to write off your business’s bad debt, it’s critical that you do so legally. Carefully follow these three rules:
1. Determine Whether Your Tax Return Is Done on an Accrual Basis or Cash Basis
Before you can write off any kind of bad debt, it’s important that you confirm whether your accounting is done on an accrual or cash basis.
With accrual accounting, income is recognized once a transaction is made. With cash accounting, on the other hand, income isn’t recognized until payment for the transaction is actually received.
The main point to remember here is that you cannot write off a bad debt if you have yet to report it as income to the IRS. So, if your business uses the cash method, you cannot write off that bad debt. If you are using the accrual method, however, you can write off the bad debt because it was considered income for your business once the transaction was made.
2. Provide Proof That the Debt Is Both Legitimate and Uncollectable
Next, you need to prove that the bad debt is real and that you have made reasonable attempts to collect the debt.
To achieve this, you will need a copy of the invoice, as well as proof of delivery — whether it’s a receipt, packing slip, or photo.
You will then need to gather proof that you tried to collect on the debt. Of course, this doesn’t mean that you have to file a lawsuit or hire a collection agency. Proof can be any documentation related to phone calls and collection letters to the customer.
3. Claim the Deduction in the Year That the Debt Went Bad
Finally, you need to make sure that you claim your tax deduction in the year that the debt became worthless or partially worthless (if the debt was settled).
If you don’t file in the correct year, perhaps because you were not aware of the bad debt until later on, you should go back and amend your tax return for that year — particularly when dealing with large amounts.
With a relatively small bad debt, however, it is fairly customary to claim the deduction in the current year.