One question that business owners often have to wrestle with at tax time is whether or not to write off a debt as “uncollectible.”
If your business uses a cash basis accounting system, this isn’t an issue for you. In a cash basis accounting system, you don’t count money that you’re owed until it’s paid to you. You can still write off any expenses related to an unpaid invoice, but you do not owe taxes on any unpaid income. If you are a very large company this also is unlikely to be an issue for you. Large companies tend to use a reserve form of accounting and have a “bad debt reserve” to which they apply bad debts.
However, if you are neither a very large or very small company, you most likely file your taxes on an accrual basis. In accrual basis accounting, the unpaid invoice shows up as income on which you owe taxes. However, if you never collect that money, you can write off the amount as a bad debt expense.
From a tax-planning standpoint, it is usually best to take your write off as soon as possible so that you get the tax deduction now, instead of later. The only time taking the deduction later would be better is if you are expecting to be in a higher tax bracket later on. This is primarily a concern for sole proprietors and S corporations, whose annual income fluctuates more widely. However, even if you expect to change tax brackets, you can not randomly decide when to write off debts. There are no hard and fast tax rules about when you can consider a debt “uncollectible,” but the IRS does like to see consistency in your tax filing methods.
Generally, it’s hard to justify classifying a debt as “uncollectible” if the debt has been owed for less than 90 days. But, some warning signs that a debt may be uncollectible, even if it’s been less than 90 days, include a company declaring bankruptcy, a company refusing to answer communication, a company stating that they will not pay you, or a company simply disappearing. Once you have turned a debt over to a collection agency, you are also justified in writing it off on your taxes. However, if the collection agency is able to collect, you will owe taxes on the amount collected.
As a commercial collection agency, we recommend that you not wait until tax season to think about how you will collect on unpaid invoices. We advise clients to consider professional help with unpaid invoices that are 90 days or more overdue, or when they start to notice any of the warning signs that a business may not be willing or able to pay its bills.
Writing off bad debt is helpful to your bottom line, but what’s more helpful is actually collecting on that debt. For example, imagine that your company is in the 33% tax bracket and a company owes you $10,000. If you write that off as bad debt, you’ll save $3,300 in taxes. However, if you hire a reputable collection agency that charges 20% of the amount collected, you could get $8,000. Earning $8,000 is clearly better than saving $3,300.
At The Kaplan Group, our goal is to make sure you are paid the money you are owed, so that you write off as few uncollectible debts as possible. Please reach out and let us know how we can help.