Tax season is here. You might be reading this article because you’ve procrastinated in completing and submitting your tax return, which is due in just over two days.
That’s OK. It’s better than forgetting about your taxes. And forgetting that I’ve written articles on tax advice recently is what I have done -- and why I am posting a tax advice article just two days before the deadline. If I don’t forget, I’ll post another before April 15. Who’s kidding who? I’ll forget.
Recently, I wrote an article about how to handle bad debts for a client. My research on the issue inspired me to write the below article on how to reduce the negative impact of uncollected debts via your tax return.
Bad Debt Problems Can Be Reduced Via Your Tax Return
The future of a business can be jeopardized if too many of its clients haven’t paid their bills, but a business can reduce the impact of these unpaid bills -- which are called bad debt -- by learning the Internal Revenue Service’s (IRS) rules on tax write-offs.
The first thing you need to do is understand the IRS’ rules on what constitutes a bad debt. The IRS differentiates between a business bad debt and a nonbusiness, or personal, bad debt. The IRS’ “Business Bad Debts” publication says that a debt incurred in a business becomes a bad debt only after the business has tried and failed to collect it for a “reasonable period of time” and the debt is now “worthless.”
“What’s a "reasonable period of time?" The IRS doesn’t say. Neither does the Small Business Administration (SBA) in its publications on bad debts. After 15 minutes researching this issue, I’m now giving up. I try very hard to answer readers’ questions, but government bureaucrats make this difficult.
The IRS publication, though, does have an interesting tidbit about what constitutes a “worthless” debt.
“To demonstrate worthlessness, you must only show that you have taken reasonable steps to collect the debt but were unable to do so,” the publication says. “It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.”
The second thing you need to understand about the IRS’ rules on tax write-offs is that you cannot deduct a business bad debt from your taxable income if the amount your customer owed you was not included in your taxable income. Consequently, the accounting method you use in your business is crucial.
The accrual accounting system reports income when it is earned, when a customer bought the products you sell for example. The cash accounting system reports income when it is collected. Businesses that base their taxable income on the accrual accounting system can deduct a bad debt from their taxable income, but businesses that base their taxable income on the cash accounting system cannot deduct income that they never received.
There are two ways you can claim a business bad debt -- the specific charge-off method and the nonaccrual-experience method. The IRS reports that most taxpayers “must” use the charge-off method and provides details on how to use both methods.
You can deduct the specific business bad debts during the same year the debt was incurred on that year’s tax return, but that’s not required. You can file a claim for a tax deduction for a completely worthless debt within seven years from the date that your tax return was due or two years from when you paid your tax bill, whichever date is later. The rules on claims for a partly worthless tax debt are different. The time between when you filed a tax return and your claim is three years instead of seven.
Sole proprietors should use a Schedule C tax form to report their taxable income and business bad debt deduction, while other small businesses should use a business income tax return.
"How to Write Off Bad Debt," a FOXBusiness article, points out that your financial records should have proof that the bad business bad debt was genuinely for business rather than a personal gift.
The rules for claiming a tax write-off for a nonbusiness bad debt are far more stringent than the rules for claiming a tax write-off for a business bad debt.
"Nonbusiness bad debts must be totally worthless to be deductible; it’s an all or nothing proposition since you cannot deduct a partially worthless nonbusiness bad debt," according to “Taxes From A To Z(2013): B Is For Bad Debt Expense,” a Forbes magazine article.
The Forbes article, the FOXBusiness article, and this SBA article all have excellent advice on how to handle bad debts.
|