IRS restrictions apply to bad debt deductions

Published 9:00 pm Thursday, February 19, 2004

One of the big letdowns some new business owners suffer 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 lessons canceled 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, in order for a business to deduct a bad debt, there has to have been some kind of tangible investment that’s been lost. So nonpayment for manufactured goods — or money that was loaned — can be deducted.

Paul Gada, a senior tax analyst with CCH Business Owners Toolkit of Riverwoods, Ill., noted that a bad debt has to be for something that can be quantified. There’s no fair market value on a consultant’s time, but there is one on a shipment of goods.

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.

"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.

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’re owed, not necessarily when they’re paid.

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," Lazor said.

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

A caveat: You can only deduct a bad debt 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 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, 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."

Small Business is a weekly column on the topic by the Associated Press.