Business Tax Deductions - How to Deduct a Bad Debt

The purpose of this article is to answer the question: "What do I do if a customer or client doesn't pay me? Do I get to deduct the lost sale amount?"

Of course, this is a common problem in any business. Oh that we never encountered a bad debt or an uncollectible account receivable!

Perhaps you sell products on credit, and the customer doesn't make good on his promise to pay. Or you may provide a service and do not require payment at the time the work is performed, and send an invoice which the client refuses to pay.

After months of unsuccessful collection attempts, what's a small business owner to do?

Do you get to write it off? The answer: Maybe.

Here's the deal: You may be able to deduct the bad debt as an expense. It is also possible that you may not be able to deduct the bad debt. Whether or not you get to take this deduction depends on whether you report your sales under the "Accrual Method" or the "Cash Method" (more on that in a moment).

Here's the general rule: You can take a bad debt deduction for uncollectible accounts receivable only if the amount owed you was included in your gross sales either for the year the deduction is claimed or for a prior year.

And whether you included the amount in your sales depends on whether you use the "Accrual Method" or the "Cash Method" of income reporting, so let's take a closer look at these two methods.

#1: The Accrual Method.

If you use the accrual method of accounting, you normally report income when you make the sale or provide the service, regardless of when the customer actually pays you.

Example: You provide consulting services to a client in December 2008. After performing the services, you send the client an invoice dated 12/20/08. The client sends you a check as payment of this invoice in January 2009. If you are using the Accrual Method, you report the invoice amount as income on your 2008 tax return, even though the client pays you in 2009.

Now, let's say the client turns out to be a jerk and doesn't pay you. It's now 12/31/09 and you haven't received a dime. You've sent monthly statements, you've made phone calls, you've done everything you can to get the guy to pay, but he offers one lame excuse after another.

The prospects of getting paid look bleak, so you are now entitled to write off the bad debt on your 2009 return, because you included the amount as income on your 2008 return.

#2: The Cash Method.

If you use the cash method of accounting, you normally report income when you receive payment.

Let's re-visit the scenario described above, but this time let's assume you are using The Cash Method. The client didn't pay you in 2008, so you didn't report the income in 2008. Likewise, he didn't pay you in 2009, so you don't report any income for this work in 2009.

Since you didn't report the income, you don't get to report a bad debt expense. You cannot take a bad debt deduction if you never included the amount in income.

Here's one final point. You may now be asking, "But what about the expenses I incurred to make the sale?" If the uncollectible debt is for a product that you had to purchase and place in inventory, you will deduct the cost of that item through your Cost of Goods Sold account, because at the end of the year, that item will not be in inventory and its cost will be reported on the Income Statement automatically.

Similarly, if you incurred any expenses to provide a service, such as wages or materials, you do get to deduct those expenses.