A client, let’s call her Amy, came into my office and told me her sad story about a sale she had made. She did the work but the client never paid and she wanted to know if she could write it off as a bad debt. I am asked this question on a regular basis. I explained to Amy that in a sense she had already written it off because instead of recording a sale, she’s recording a big zero, which is exactly what she got. You can’t reduce it twice.
If she had collected the money from the client, she would have a sale. She said, “But the job was worth $2800. Can’t I write off the value of that job - $2800 - as a loss?”
Here’s how the process works: First of all, in order to write off business bad debt you must make sure that you have a bona fide business operation. Check out this FOX Business article on Hobby Losses to make sure you qualify. You must then be on the accrual method of accounting.
Because Amy is on the cash basis of accounting, she cannot take the lack of sale and a $2,800 loss on top of it. It’s the same thing. Basically, you take the loss indirectly by not having a sale to report.
So in this example, if Amy were on the accrual basis, she would show $2,800 in income accrued and then write off $2,800 as bad debt. The net result is the same as it is for a cash basis taxpayer – zero.
Any incurred expenses relating to the sale are deductible. So in Amy’s situation, she had a consulting contract for $2,800. Amy paid her employee Susie $1300 to complete the contract and they racked up expenses for office supplies and software totaling $500. Those expenses are deductible, but the IRS does not allow you to deduct the loss of your profit. In this example, Amy shows zero in sales and $1,800 in costs for a loss of $1,800. The difference between the sale $2,800 and her costs of $1,800 is $1,000, which would have been taxable income had she collected from her client. As it stands, she will show a loss of $1,800 on this contract.
Amy understood the concept but was upset about the amount of time she had put into the project. “I spent an hour selling the concept, another hour talking to Susie about the scope of the job an another hour reviewing the final product. That’s three hours I spent. My hourly rate is $125 so can’t I write off $375?”
In general, your time is worth nothing to the IRS. So when it comes to bad debt, you cannot assign a dollar value to your time and take it as a loss. This principal also holds true with donations of time. If you are a manicurist, donating your services to a women’s shelter does not qualify for a deduction, except for the cost of the supplies you use to perform the services, vehicle expense to take you from the salon to the shelter and back again and any other costs you may incur.
Bad debt could also be in the form of a bounced check. The customer has paid you, you’ve recorded the sale and the payment, but when the check bounces and is not redeemed by the customer, you may now take a deduction for bad debt. Note that this is a similar model to the accrual method; the sale is recorded and rather than payment, a bad debt is recorded against it resulting in zero.
Bad debt is deducted on Schedule C of your tax return if you are a sole proprietor or on your business tax return if your legal structure is corporate or partnership.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.