What is bad debt?
Gather around for story time, everyone!
Here’s the story of Ms. B and her bad debt.
Meet Ms. B.
Ms. B has a small business. In her business, she pays 35% tax on her income.
Ms. B invoices clients for her services. The problem is some of them don’t pay. Now Ms. B has bad debt.
Does she have to pay tax based on all the invoices she issued, or only on the cash she receives? Can she deduct the invoices that were unpaid as expenses?
What ever is Ms. B to do?
Storytime over. Sorry for the cliffhanger ending.
These are all valid questions that Ms. B must face. You may also have these questions about your own business.
In the real world this actually happens a lot. If you own a small business, you’ll struggle with non-paying customers. It’s a fact. And it’s not just you—many small businesses struggle with bad debt.
You might ask, “Maybe Ms. B can’t deduct her bad debt, but can I deduct mine?”
Unfortunately, it isn’t a simple yes or no answer.
So, now you’re wondering what do you do with this bad debt when it comes to paying taxes? It gets confusing, but don’t worry. We’re here to unfuck the situation and make it less confusing by giving some guidance.
Let’s dive in.
What is a Bad Debt Expense?
In simple terms, a bad debt expense is an invoice gone wrong. It is a receivable that likely or definitely won’t be collected.
For example, when you issue an invoice for $1,000 and the customer ghosts you, that invoice becomes a bad debt expense.
When Can a Bad Debt Expense Be Recorded?
There is a difference between recording and expense and deducting an expense. (Mind blown? Any questions, ask your accountant!)
Generally, once the invoice becomes uncollectible you’ll want to get it off your books as a receivable. But deleting or voiding the invoice is not the best move, that would wipe it out of existence totally, and it shouldn’t be wiped out because it actually happened, you’re just not getting the income from it. So, instead of deleting/voiding the invoice, you can adjust it off to Bad Debt Expense.
Just because you have a bad debt expense on your financials does not necessarily mean it’s deductible. But why? What’s the difference? Keep reading!
When Can a Bad Debt Expense Be Deducted?
A bad debt expense can only be deducted if you are an accrual basis taxpayer. If you have no idea wtf that means, you’re probably not an accrual basis taxpayer. Most small businesses are cash basis taxpayers.
- Cash basis taxpayers pay tax on what was collected/paid
- Accrual basis taxpayers pay tax on what was earned/incurred, regardless if it was paid or not
If Ms. B uses accrual accounting, she must pay taxes on the amount of the invoices she issues for the year the work is done – regardless if those invoices are actually paid. Later on, if customers don’t pay, those invoices become deductible bad debt expenses, because she already paid tax on them.
Now, if Ms. B uses cash accounting, she only pays tax on the invoice payments she receives. So she can’t deduct any bad debt expenses on her taxes because she never paid tax on that income in the first place. She’ll still be able to deduct the expenses that she paid for, like labor and supplies, but she will never have a bad debt expense.
Now you might think, “But what about the value of the services I provided?” We know. This is what would make sense logically. But the thing about accounting is – whatever seems logical, do the opposite! Unfortunately, you won’t be able to deduct the value of your time either in that way.
- If you use accrual accounting principles, you pay taxes on the amount of your issued invoices. If you incur bad debt, it’s deductible on your taxes.
- If you use cash accounting principles, you pay taxes on the payments you receive. If you incur bad debt, it’s not deductible on your taxes.
How to Report a Bad Debt Expense
You can record bad debt expenses in one of two ways:
- The direct write-off method
- The allowance method
Wait, what? Let us explain.
The Direct Write-Off Method
With the direct write-off method, you charge the invoice directly to the bad debt expense account. This method is more like a 1:1 compared to the allowance method and each figure in the bad debt expense account can be directly traced back to a specific invoice. In accounting terms, you debit the bad debt expense account and you credit the accounts receivable account thus removing the invoice from AR.
The Allowance Method
Let’s compare that to the allowance method. Under the allowance method you can estimate bad debts and make allowance for them before they occur. You then use this allowance to “pay” all the bad debts in future.
Now, which is best? Well, it depends. If you’re an accrual basis taxpayer or maintain GAAP books, talk to your accountant about which bad debt method is best for you.
The sad truth is that bad debt can bring your business to its knees. It’s even worse when you have to pay taxes on income you didn’t receive. Implement strong collection practices in your business, take deposits upfront, don’t work with companies that don’t pay you timely, assess late fees, make it EASY for clients to pay you, and tweak your methods over time as your business evolves.
To sum it all up:
- There’s a major difference between recognizing bad debt expense on your financials and actually deducting it on your taxes
- Only businesses that are accrual taxpayers can deduct bad debt on their taxes
- You cannot write off your time as bad debt theoretically
- Talk to your accountant about the direct write-off method or the allowance method if you’re an accrual taxpayer or use GAAP in your business
Please reach out, we’d love to help!
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Countless assumes no liability for actions taken in reliance upon the information contained herein.