There are two kinds of bad debts that might affect your business: debts customers owe you, and debts your business owes to suppliers or service providers. Both types have tax consequences. Here’s a look at what happens to bad debts at tax time.
Debts Customers Owe You
If a customer buys a product from you on credit but never pays the bill, your business has a bad debt. To deduct this loss on your tax return, the loss must meet some requirements:
- The debt must be 100 percent related to the operation of your business.
- The debt must have been previously reported or recorded as revenue by you (perhaps in estimating your income for figuring quarterly tax payments).
- The debt must relate to the sale of a product or service for which you incurred costs. If you rendered a consulting-type service with no associated costs, you don’t have a write-off.
The amount you can write off for this bad debt is not the full amount you charged the customer for your product or service. You can only write off the cost of goods relating to this unpaid bill: the amount you paid for the items purchased or used by the deadbeat customer.
So if you manufactured a watch for $100 and sold it to a customer for $200, your deduction is just $100. If you have a carpet-cleaning service and you used $20 worth of cleaning supplies to perform this service for your customer, that is all you can write off. Unfortunately the value of your time or expertise is not figured into this deduction.
Debts Your Business Owes
If your business purchased supplies or services, say, advertising, on credit and then didn’t pay the bill, the company that provided those goods or services now has a bad debt on their books. If you negotiate on this debt and settle it for a lesser amount, or if you have the debt forgiven, known as debt cancellation, there are tax consequences.
Usually if your business settles an outstanding debt, that is bad news at tax time because your business must report the canceled part of the debt as income. This is a bad situation, for obvious reasons: You’re so cash strapped you couldn’t pay your bill and settled the debt for a smaller amount, and now you’ve increased your tax bill.
The good news is that the American Recovery and Reinvestment Act of 2009 gives cash-strapped businesses a break on debt settlements. For 2009 and 2010, any debt you settle will enjoy a tax deferment for five years. So if you settle a debt in 2010, you won’t have to report the canceled debt amount as income until your 2015 tax return. The idea is to give businesses a chance to recover and pay the additional tax when the economy has improved. It expires in 2011, and canceled debts must be reported as income on the tax return for the year in which the debts were settled. So if your business has outstanding debts, consider settling them promptly, while the ARRA’s tax deferment for canceled debts is still in effect.
Business reporter Carol Tice contributes to several national and regional business publications.