Gah! A client didn’t pay. Can you write it off?

How to deduct bad debt

Maybe this has happened to you: You get a call from someone who wants you to do some work for them, and you give them what you consider a fair quote. They accept it, and you get to work. You work hard to complete the job to the best of your ability. You send it to them; they tell you how much they like what you have done, and ask you to send them an invoice. You shoot out the invoice within the hour — and start making plans for a classy dinner with your spouse to make up for all the family events you missed while you were head-first in this project.

Then … nothing.

A month or two goes by, and still no payment from the client. You email them, and get no response. You call them, leave several phone and text messages, and never get a call back (or worse, get a “this line has been disconnected” message). So, are you screwed? Is there nothing you can do about it? That charge for that expensive make-up dinner is sitting on your credit card, drawing interest charges that seem to laugh at you every time you open a bill.

However, not all is lost. You can still claim the bad debt on your taxes as an expense — as long as you’ve done a few things.

Are you ready for the write-off?

In order to claim bad debt as an expense, you would have first had to include the amount of the invoice in your revenue. Since you sent the invoice to the client, you probably recorded the amount as a receivable — so your accounting system will have recorded the invoice in revenue.

On the other hand, if you record income when you get the check from your client, you can’t deduct the bad debt, because you never sent the invoice and never recorded the revenue.

Second, you have to have no reason to expect that you will ever get paid. You will have to prove that you have taken reasonable steps to collect the debt, which means keeping a log of your calls and copies of your emails and letters. You might want to send your last letter certified so that you have some proof from the post office that you tried.

How do you claim bad debt?

OK, so you have proved that the debt is worthless. How do you claim it on your taxes? There are two ways to do this:

  1. Write off the specific debt that has gone bad.
  2. Do an accrual for income from service that you expect will be uncollectible.

The second method is only used by certain types of businesses — such as architecture, accounting, actuaries, consulting, engineering, health, law or performing arts — that have met the $5 million gross receipts tests for all prior years. As you can guess, most small businesses will use specific write-off.

What if they pay you in the following year?

In this case, you have income that will need to be reported on your tax return. This would be included in the line for other income. So, maybe you aren’t out of luck. Perhaps you can pay off that dinner after all.

The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.

Image by: msaari via Visual hunt / CC BY-NC-SA

Chris Peden
Chris Peden, CPA, CMA, CFM has spent more than 15 years in the corporate world helping companies meet their regulatory compliance requirements. He also assists small business owners with organizing and making sense of their finance information.