With another tax season just recently passing, many small business owners across the country just recently made decisions regarding write-offs on uncollectible debts. However, there is no reason to wait until your taxes are due to think about how you want to handle your outstanding debts.
In order to better help you prepare for next year’s appointment with your accountant, let’s take a quick look at how writing off uncollectible debts can impact your bottom line this year.
Cash or Accrual?
Remember that first day of Accounting 101 when the professor started droning on about cash basis and accrual basis accounting? You probably don’t remember the details, but believe it or not, they actually do matter.
If your business operates on a cash basis, then you only record billable work as income when you receive payment for that work. For this reason, there is no need for any business operating on a cash basis to write off bad debt because they have never recorded that debt as income in the first place.
However, if your business operates on an accrual basis, then you record and pay taxes on any work that you send an invoice for. In those situations, you still have to pay those taxes even if you never receive payment for your services.
Do You Need the Write-Off?
If your business operates on an accrual basis and has some outstanding debts on the books that you might never collect, then you are probably eligible to write off those debts as uncollectible. This will reduce your taxable income by the amount of the debt.
Depending on where you expect your business income to fall for the year, this could be a great help in reducing your tax liability. But if you don’t need the write-offs this year, you could also consider letting them ride until a year where your income is higher.
Can You Justify the Write-Off?
When deciding whether or not to write off an uncollectible debt, it is important to remember that the IRS likes to see businesses that operate with some consistency on their write-offs. It is also important to go out of your way to avoid raising any red flags.
One red flag that could potentially get you in trouble is writing off a debt that is less than 90 days old as uncollectible. Barring a situation like bankruptcy or a written statement refusing payment, a debt that is less than 90 days old is just not far enough along to be considered uncollectible.
What About Collection Agencies?
It is also important to remember that working with a commercial debt collection agency is often a better option than writing off a debt as uncollectible. In most situations, the amount an agency recovers for you will be more than you would have saved on your taxes, even after taking out their contingency fees.
One way that you can have the best of both worlds is to write off a debt as uncollectible and then pass it on to a collection agency. This will allow you to gain the immediate benefit of the write-off, and also leave the door open for the possibility of recovering the debt down the road.
Of course, if a collection agency is able to recover a debt that you have already written off as uncollectible, you will be required to pay taxes on that additional income.
Determining whether to write off various debts as uncollectible is a tricky situation that involves a number of moving parts. It is always best to consult with a licensed tax advisor before doing anything, and it is also a good idea to have these discussions throughout the year, not just at tax time.
