Hear me out please. I am going to address bad debt expense to clear up a common misconception and hopefully I can write this an understandable way. This seems to come up every year and it is a difficult concept for some to grasp.
What is Bad Debt Expense?
What is Bad Debt Expense? I will quote the IRS:
If someone owes you money that you can't collect, you may have a bad debt. Generally, to deduct a bad debt, you must have previously included the amount in your income or loaned out your cash.
What is not a deductible Bad Debt Expense?
If you are a cash basis taxpayer and someone fails to pay an invoice that you sent them, that is not a bad debt expense that you can deduct on your tax return. I know it is bad that you did not get paid for the work that you did or a product that you sold. I get it. But unless you are an accrual basis taxpayer that reports all invoiced sales as revenue then you generally don't get to deduct a bad debt expense for someone who fails to pay your invoice. As the IRS quote includes "to deduct a bad debt, you must have previously included the amount in your income."
What you get to deduct
What do you get to deduct? You get to deduct any expenses associated with the sale at the time the expenses were incurred except for inventory. For inventory you get to deduct it at the time of the sale. In this case, as a cash basis taxpayer you don't record the sale but you do record the cost of goods sold for any inventory that was sold.
What is the end result
The end result of some one not paying your invoice is you get to deduct all the expenses incurred for the sale. You don't get to take bad debt expense, as a cash basis taxpayer, but then again you also did not record the income because you did not receive payment of your invoice. As a cash basis taxpayer your taxable income is the revenue you received less the expenses that you paid, in general terms. That is it. That is the way it works. I know many don't like it and it may not seem fair to you and it is not fair. The part that is not fair is that you did not get paid for what is rightfully yours. And if you had previous recognized the income on your tax return as an accrual basis taxpayer then you would get to deduct it but the end result for the accrual basis taxpayer is the same as it is for the cash basis taxpayer. You don't end up after the bad debt deduction with any revenue related to that sale because you recognized the revenue in the year of the sale and then took the deduction for the same amount in the year you recognized you could not collect it and the deduction was the same amount as the sale (usually). For both the cash basis taxpayer and the accrual basis taxpayer after everything gets recorded you wind up with your expenses associated with the sale as deductions and that is it. The revenue if recorded gets offset by the bad debt deduction. If no revenue was recognized there is no bad debt expense. That is it.
I hope this helps but it is a concept that can be difficult to understand once you have it in mind that you, as a cash basis taxpayer, should be able to deduct bad debt expense. I get it, that part, but you can see this explanation from the IRS if you still don't understand it.
Taxes are very involved and as shown above it can get complicated and that is where I come in to the picture. With your tax returns there may be a lot to discuss and strategies that can be pursued. I have been through this before and I would be glad to help to you if you have a complicated tax return. To get started use my email address below to arrange an appointment to have an initial consultation. We can do the consultation over the telephone, or using Zoom, or another option.
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Be careful when reading about tax law and its application, including my articles, because the wording and definitions are such a challenge and are influenced by writers perspective, specifically his own clients situations that he is mindful of and other situations the writer is not thinking of. The point is talk to your CPA about your situation and circumstances and don't rely on or make conclusions based on articles you read, including articles form irs.gov, because concepts and definitions are not very clear, and of course, they are subject to change. Now is the time to be having discussions about your situation and developing strategies for you and your business. Again, contact me using my information above to discuss your situation. I help business owners all over the U.S. and in foreign countries with their tax returns.