If you are unable to recover any of the money owing, the loss might be tax deductible. Bad debts by the business are made as a deduction for your business as a typical write-off. For instance, if you weren’t paid for goods that you shipped even after collection activities have been exhausted and the money is uncollectible (e.g. the company you shipped the good to is no longer in business), you are able to deduct the loss.
If you lent money that is not repaid, you have to figure out if it is non-business bad debt or business bad debt. If your business loaned an employee money who is not able to repay the loan (e.g. they are bankrupt), this is business bad debt. It is more challenging if you lent money to your business and it doesn’t repay it:
- If the money was lent in order to protect your job, this is a business bad debt which is deductible if it isn’t repaid as a typical business loss.
- If the money was lent to protect your investment, this is a non-business bad debt, which is only deductible in cases where the debt is fully worthless. It is considered a short-term capital loss irrespective of the amount of time the debt was outstanding.
Caution: If you are using the cash approach of accounting and you don’t get paid for services, you have no recourse. Tax deductions, unfortunately, cannot be made for lost time and effect.
See the IRS Publication 535 for tax rules about deducting bad debts.
Lessons for the future
If it has been a painful experience to collect from tardy or delinquent clients, stop it from ever happening again. Set up your payments for your goods or services so that you are not in a position where you have to collect after they have been delivered. Receive payments up front. Do this by providing a number of payment alternatives to the customers such as debit/credit card, check, cash or electronic payments like Amazon Payments or PayPal. Take electronic payments instantly with devices like Intuit, Square etc. that turn your smartphone into a payment processor.
Use smart invoicing policies if you absolutely have to give invoices. Send them electronically and if payment isn’t received follow up with them right away.