Harvest Your Business Bad Debts.
Extending credit to customers is a necessary evil when it comes to running a business. Unfortunately, not all customers or debtors ultimately pay their bills. When this occurs in the operation of, or is closely related to a trade or business, it is known as a business bad debt and is deductible against operating income. A debt is closely related to your trade or business if your primary motive for incurring the debt is business related. Bad debts of a corporation (but not an S corporation) are always business bad debts. All other bad debts are considered nonbusiness bad debts and are deductible only as short-term capital losses.
You can claim a business bad debt deduction in the current year only if the amount owed becomes partially or totally worthless and was previously included in gross income from all sources including sales, services, rents, and interest. Generally speaking, this only occurs if you use the accrual method of accounting whereby you report income as you earn it (when goods are delivered or services are performed) and record an account or note receivable.
On the other hand, if you use the cash method of accounting, you generally report income when you receive payment. You cannot, therefore, claim a bad debt deduction for amounts owed to you because they were not previously included in income.
A debt becomes worthless when there is no longer any chance the amount owed will be paid. This may either occur when the debt is due or prior to that date. To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so. A lawsuit is not necessary if a judgment from the court would be uncollectible. A debtor’s bankruptcy is generally good evidence of the worthlessness of at least a part of an unsecured debt. The charge off of partially worthless debts can be delayed until a later year, but no portion of a debt can be deducted after the year it becomes totally worthless. Also note that the deduction for a partially worthless debt is limited to the amount actually charged off on your books, so it is a good idea to record it in the appropriate year.
To illustrate, a customer contracts with a cash basis self-employed IT specialist to install a computer network and purchases the necessary hardware and software from a separate computer vendor who uses the accrual basis and accordingly records a sale and an account receivable on delivery. The IT specialist completes the project and bills the customer. Despite collection efforts by both parties, the customer subsequently fails to pay either the IT specialist or the computer vendor. As a result, the computer vendor has a bad debt deduction because it previously included the sale in income, but the IT specialist does not since he only records income as received – same customer, same project, different accounting methods; different result.
If not already in process, the end of the year is the time to document your phone and email contacts, to issue dunning letters or to hire a collection agency. If all else fails, record your bad debt write offs.
When it comes to serving your accounting needs, no one has more experience than our team at DSJ. Call us today at 516.541.6549 or email us at to set up an appointment. We look forward to working with you!