Can I deduct unpaid invoices?
CAN I DEDUCT UNPAID INVOICES?
This question delves deep into a persistent issue faced by many businesses and entrepreneurs —the challenge of dealing with customers who either delay payments or fail to pay altogether. It's a scenario that likely resonates with most, if not all of us, at some point. Perhaps it's due to overlooking or misplacing an invoice, or in today's digital age, accidentally deleting or misfiling the email containing the invoice. Beyond inadvertent reasons, deliberate causes such as temporary cash flow problems or downturns in a customer's business also contribute to late or non-payments.
Regardless of the cause, we must empathize with business owners who rely on timely payments to meet their own financial obligations. After all, how can a business sustain itself if its customers don't settle their dues for goods or services provided?
While delving into the intricacies of debt collection is beyond the scope of this discussion, we can focus on managing unpaid invoices from an accounting and tax reporting perspective.
Two primary accounting methods are commonly employed by businesses:
Cash Basis: Predominantly used by small businesses, this method records income when received and expenses when paid.
Accrual Basis: Under this method, income is recorded when goods or services are provided, and expenses are recognized when incurred, regardless of payment timing.
In routine business operations, transactions recorded annually serve as the foundation for income tax reporting.
Now, turning to unpaid invoices, let's illustrate how they're handled for tax reporting by two small businesses using different accounting methods.
Example 1: Joe, a plumber, follows the cash basis. In December 2023, he invoiced Chuck $2,000 for replacing his hot water service. By May 2024, Chuck hadn't paid, and Joe discovered Chuck had moved without providing a forwarding address. Because Joe didn't receive the $2,000, he didn't record it as income in 2023, thus he can't deduct the unpaid invoice.
Example 2: Joanna, using accrual accounting, repainted Chuck's rooms around the same time as Joe's work. She invoiced Chuck $1,500 and recorded it as income in December 2023. Although unpaid, she'll deduct the invoice in her 2024 tax return because she included it as income in 2023.
In both cases, Joe and Joanna incurred losses from unpaid invoices, but only Joanna can deduct it in 2024 because she included it as income in 2023.
However, a business cannot simply deduct an unpaid invoice without justification. The debt must be deemed worthless, which the IRS defines as having no chance of repayment. This may occur by the due date or earlier, and the taxpayer must demonstrate reasonable efforts to collect the debt. Evidence like the debtor's bankruptcy or disappearance supports the claim of worthlessness.
In summary, you can deduct an unpaid invoice as a business expense if:
You've reported the amount as income on your tax return.
You've made reasonable collection attempts without success.
The debt is worthless with no chance of repayment.
If you are still unsure about your situation, and want expert advice, you can click this link to set an appointment to speak with a Tax Expert from Lisa Brugman, EA & Associates.
