Have you ever experienced difficulty collecting payment for a product or service you provided? If a client fails to pay you or your business for services rendered, it could be considered a bad debt expense (uncollectible account), which in certain circumstances can be fully deductible. In addition to being a deductible business expense, there are also a few situations where you may be able to deduct nonbusiness bad debts on your 1040.
Tammy is a landlord that rents out her free standing guest house on a month to month basis independently using craigslist and newspaper ads. Last summer, Tammy had a tenant who chose to move out of the rental property three months earlier than she was expecting. When Tammy filed her tax return this year, her accountant informed her she would not be able to claim the three months of unpaid rent as bad debt on her Schedule E since Tammy is a cash basis taxpayer (rental income recorded when cash is collected) and nonpayment of expected income does not qualify as a bad debt deduction.
In December, Jerome, a successful author, sold copies of his new book to five local bookstores for $15,000 with 60 day payment terms. Since Jerome prepares his tax return on an accrual basis, he recorded $15,000 of revenue on December 31st. Unfortunately, some of the book stores failed to pay him within 60 days. After 120 days and $500 spent on collection fees, Jerome was able to collect $9,000 of the $15,000 owed to him, but realized he wouldn't be able to collect the balance because two of the local book stores had gone out of business. When Jerome prepares his tax return he will be able to deduct $6,000 ($15,000 revenue recognized less $9,000 collected) of bad debt expense and $500 of collection fees on line 27a of his Schedule C.
Grayson is an avid Uber driver who recently decided to start his own fleet operation. Grayson made a legally binding arrangement with his childhood friend (and first driver), Jane, that his business would loan her money so she could buy her own vehicle to use for uber, provided she pay him 25% of her net uber fares during her first twelve months driving. In January, Grayson loaned her $15,000 expecting to be paid back in $5,000 installments on March 15, June 15, and September 15. His friend was able to make the first and second payments but unfortunately was not able to make the third payment because the car was stolen and she declared bankruptcy. Since this was a legitimate loan made form his business, Grayson incurred an actual loss, and the debt is uncollectible he will be able to deduct the $5,000 as a bad debt expense on line 27a of his Schedule C.
Gabriella Summers, a San Francisco based web developer charged a startup client $45,000 to develop a mobile application and the recognized revenue for her work. Unfortunately, the client was unable to secure their first round of funding and was unable to pay Gabriella. Gabriella determined the receivable was totally uncollectible and her tax accountant deemed it appropriate to deduct the bad debt expense. The following year, the startup secured $20 million of funding and finally paid Gabriella for her work. When she prepares her tax return this year, she would report the $45,000 of recovered bad debt as other income on line 6 of her Schedule C.
Athena is an entrepreneur who owns her own massage therapy business. Two years ago she provided extensive services to a local sports team but was unable to collect amounts due to her. Since Athena is an accrual basis taxpayer, she recorded her fees for services rendered as revenue in the year the services were provided despite having not yet collected payment. After two years of extensive litigation, Athena has determined the balance due to her will never be collected. Even though it has been two years since she first recorded the revenue, she can still deduct the uncollectible balance as a bad debt expense on her Schedule C this year since it is the first time she has been able to determine that the receivable is totally uncollectible.
- To be able to deduct a bad debt expense the following must be true: Uncollectible amounts need to be related to a business purpose, you must prove amounts owed to you will remain uncollectible, you must have incurred an actual loss (i.e. loaned out money and not paid back, provided services and recognized taxable income but were not subsequently paid for your work, etc.), and there must be a legally binding arrangement and relationship between you and whoever owes you money.
- If you are a cash basis businesses and you only record income at the time of collection, you will not be allowed to deduct bad debts for payments you were hoping to receive but never did since these amounts would not have been included as part of your taxable income.
- Nonbusiness bad debt expenses can also be deductible on your 1040. You may be able to deduct personal bad debts if the debt is totally worthless, the debt is related to amounts you previously reported as income or loaned, and there is legally binding arrangement. Nonbusiness bad debts are deductible as short-term capital losses on form 8949.
- Bad debt is different than theft. For example, if you paid an attorney for legal advice, relied on it, and later found the advice to be fraudulent but could not get a refund, this would be considered a theft loss rather than a bad debt expense. Generally, a bad debt expense will only be between you and a customer, client or borrower.
