- The Washington Times - Tuesday, February 24, 2004

One of the big letdowns for some new business owners during income-tax season is when they find out they can’t deduct their bad debts — bills their customers didn’t pay during the previous tax year.

Under the Internal Revenue Code, a music teacher who had canceled lessons can’t deduct the fees students never paid. And a landlord whose tenants left without paying can’t deduct the lost rent.

But manufacturers who delivered goods and weren’t paid are more likely to be able to deduct their bad debts.

Generally, for a business to deduct a bad debt, there has to have been some kind of tangible investment that has been lost. So nonpayment for manufactured goods — or money that was loaned (and documented by a promissory note or loan agreement) — can be deducted.

Paul Gada, a senior tax analyst with CCH Business Owners Toolkit, a service based in Riverwoods, Ill., noted that a bad debt has to be for something quantifiable. That’s why services and rents that weren’t paid for cannot be deducted. There’s no fair market value on a consultant’s time, but there is one on a shipment of goods.

Accountants note that a company’s accounting method tends to determine the deductibility of bad debts.

There are some exceptions but, as a rule, a company that uses the cash-basis method of accounting won’t be able to deduct a bad debt. But a company that uses the accrual method, and that’s likely to be a manufacturing concern, has more opportunity to use the deduction.

Under cash-basis accounting, used by most firms that are service providers, income is recognized when it is received, and expenses are recognized when they are paid for.

“If they’re on a cash basis, then they have not recognized the income for which someone has not paid them and they do not have a bad debt,” said Bill Lazor, president of the Pennsylvania Institute of Certified Public Accountants and a partner in the Kingston, Pa., firm Kronick, Kalada & Berdy.

That doesn’t mean that the cash-basis business didn’t have the expectation of performing a service and being paid; it’s just that the law doesn’t recognize a debt as having been incurred if no service was performed.

Meanwhile, under accrual accounting, income is recorded when a sale occurs, or a debt is owed, not when payment is received; conversely, expenses are recorded when they are owed, not necessarily when they are paid.

Mr. Gada noted that some cash-basis businesses do list a sale as income in their books. Under those circumstances, they might be able to deduct a bad debt.

It’s important for a business owner who can deduct bad debts to understand what a bad debt really is. A payment that’s late on Dec. 31 isn’t a bad debt. Nor is a payment that’s 90 days late.

“It’s deductible only after you have exhausted all sources of collection, and that means you’ve at least tried to make phone calls and encourage the person to send money,” Mr. Lazor said. You also can’t automatically deduct a debt if you have the ability to repossess goods or file a lien against them.

“You can’t just throw up your hands and say I can’t collect it,” Mr. Lazor said.

If your customer files for bankruptcy, Mr. Lazor said, there is an assumption that you won’t be paid, and you can deduct the money you’re owed.

A caveat: You can deduct a bad debt only in the year it became bad. You can’t hold on to it and use it in another year when you need some extra deductions.

All business owners can deduct the costs they incur trying to collect a bad debt — collection agency and attorney’s fees, for example. That can be some small consolation for those who cannot deduct the debts themselves.

Not being paid in the first place and then having the government limit or prohibit the deductibility of a bad debt can feel like a bit of double whammy. But smart business owners will protect themselves, creating a pricing, fee or rate structure that assumes there will be unpaid bills, canceled appointments or delinquent rent payments.

For example, Mr. Lazor said, “a landlord would draw up a potential rent roll for the building, taking into account vacancy percentages and taking into account you’re not going to get paid.” And, he said, “Get a good security deposit up front.”

Other service providers also should factor possible nonpayment into their rates, but also should consider requiring partial payments, especially in the case of a new customer or those who take their time paying.

Such steps mean that you won’t have to fret about the government not bailing you out at tax time.


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