Have Bad Business Debts? How They Can Help Your Taxes
Unfortunately, for nearly all business owners, bad debts are a fact of life. But when they occur, you can use them to aid your bottom line for tax purposes. How? Here is what you need to know about deducting bad debts at tax time.
You Must Use Accrual Accounting
If you or your business uses accrual-based accounting, you include income and expenses when they are earned rather than when you receive or pay the money. This generally includes inputting accounts receivable when you bill customers. Accounts receivable accounts are considered your reported income because the money is due to you. If a customer later doesn't pay, you have already included that debt as income.
On the other hand, cash-based accounting reports income and expenses generally when money changes hands. In this case, you wouldn't report a bad debt as income because you never received the money. Therefore, nonpayment has no effect on your income reporting at tax time.
The Debt Must Be Business Related
To qualify for a business expense deduction, the debt must be related to your business. Most business owners loan money or give credit to customers, so there is little doubt that the debt is related to your business.
But it can get a little complicated with specific types of loans. If you loan money to a client's college-age son, for instance, the IRS will generally consider this to be closely related to your business. If you loan money to your brother who occasionally does work for the company, it is unlikely to be business related.
You May Choose Write-Off Methods
So, if you use accrual accounting and you do have customers whose debt you're not going to see paid, how exactly do you deduct that debt to lower your taxable income? Generally, there are two methods. First and most commonly, you may write off specific and individual debts when you deem them non-collectible.
However, the IRS does allow certain small businesses in service industries to deduct a certain amount of debt that they expect to be non-collectible based on past history. To do this, you would usually analyze past years' bad debts to determine the percentage you end up having to write off during each period (monthly, quarterly, or annually). Use this percentage to write off the current year's expected bad debts.
An Accountant Can Help
Are you not sure if a particular debt is really business related? Would you like to know more about using a percentage for ease of reporting? Do you suspect that switching to accrual accounting might benefit your taxes in this and other ways? A professional accountant can help.
Look for an experienced professional who specializes in business tax matters and who has experience in your industry. Then, make an appointment to begin boosting your bottom line no matter whether you get paid or don't. For more information, contact companies like Amico & associates.