Most small businesses have receivables that cannot be collected. These receivables can be from the sale of products, providing services to customers, or a combination of the two.
Whether or not a bad debt deduction will apply generally depends upon which accounting method is used (either the cash or accrual method). Why does this make a difference? Let’s look at what happens under both methods of accounting.
- Accrual – If the accrual method is used, all of your billings must be treated as income whether or not they have been collected. This means that the taxable income already includes the income from your deadbeat customers. Therefore, these items are considered a bad debt when those receivables become uncollectible and can be deducted. If the accrual method of accounting is used, bad debts are deductible.
- Cash – On the other hand, if the cash method of accounting is used, income is not reported until it is received (unlike the accrual method). Since the income was never reported in the first place, a deduction cannot be taken if payment was never made for the goods or services that were provided. However, if you made a loan to a customer or supplier and there is a business reason for the loan, you may have a business bad debt.
Proof of Worthlessness – Proving a debt (or receivable) is worthless requires the taxpayer or business to show that the debt has become worthless and that reasonable steps were taken to collect the debt.
Non-Business Bad Debts – Some bad debts may actually be personal debts, such as personal loans to individuals. In those cases, the bad debt is not deducted as a business expense but is treated as a short-term capital loss on Schedule D subject to the $3,000 annual loss limit.
If you still have questions, please give this office a call for additional information.