Sometimes business owners have accounts receivable that will never be paid. They may also have inventory that they never use. If this feels like a loss, it’s because it is. Most small business owners want to reduce taxable income legitimately and they can with the right strategies. Ask your accountant about using your unused inventory to your advantage and writing it off as a loss on your tax return to help save money at tax time.
Even the most optimistic business owner will look at their accounts receivable and admit that there are some amounts that will never be collected. Perhaps there’s an invoice for a product that was sold to a customer a few months ago, but he hasn’t paid. Or there’s a sweet deal that was cut with a company in Nebraska last winter that’s not returning phone calls anymore.
Some of these receivables aren’t receivables at all. They’re bad deals. And if you meet the requirements under IRS rules, some of these unpaid receivables can qualify as “business bad debts” that can be deductible on your taxes.
Take a look at your inventory. You’ll see lots of inventory that’s being used for jobs or that was freshly purchased specifically for an order received. But there’s other “stuff” that’s just sitting in your warehouse or storeroom. Some of this stuff you bought at a low cost, thinking you’d be able to sell it at a nice profit. Or maybe you purchased it for a customer whose business soon went under and then they couldn’t pay you. Some of that inventory you’re not going to be able to sell. Those purchases were bad deals, too.
Being in business means sometimes making bad deals; it’s inevitable. It doesn’t mean you’re a bad businessperson. It means that you’re just a businessperson. You took some risks and sold stuff to someone who probably didn’t have a great credit history, but you felt confident they’d pay up. Or you bought something for a great price with the hopes of selling it for a larger margin than your typical items. When you make deals and take risks, sometimes things don’t work out. And that’s OK! The fact that you’re still in business means that more of your deals and risks are working out, right? You’re having more successes than failures.
So, what should you do with that bad receivable or un-sellable inventory? Consider getting rid of them both. You could possibly write them off your books. In the case of the inventory item, you could perhaps take it out of your storeroom and physically dispose of it. There are a few options for possible tax deductions when getting rid of obsolete inventory, depending on your method of accounting and your overall tax situation, but the rules are complicated, so talk to your accountant first to see if you qualify.
For example, you might be able to give away the obsolete inventory as a charitable donation to a nonprofit organization, have a clearance sale to sell the inventory at a loss, or physically destroy the inventory if no buyer or recipient can be found. Remember: Not every business will qualify for a tax deduction, and every situation is different — don’t assume that you can get a tax break for getting rid of your old inventory, but talk to your accountant first and see what options you might have.
Getting rid of the bad receivable can help your mood because you won’t instantly get annoyed every time you look at your list of receivables and see that customer thumbing his nose at you. Getting rid of the unusable inventory item can help free up space for better inventory, so it’s potentially a better use of your overhead. Keeping these assets around can take value away from your business. And, as business owners, our job is to increase our company’s value, not do things that diminish it.
More importantly, getting rid of these bad assets can create a tax benefit. Ask your accountant — it could be a deduction. So long as it’s off your books and disposed of, you might be able to take the write-off. So stop being so sentimental and consider taking the deduction.
It might hurt to finally have to accept the reality that you’re never going to get paid for that big customer order, or that you made a bad bet on a batch of merchandise, but taking a few losses is part of the ongoing learning experience of being a business owner. By clearing out the bad deals and bad debts, you can make way for fresh new opportunities — and you might even be able to claim some of these losses as a tax deduction.
And even if you don’t qualify for as large of a tax break as you had hoped, it will still feel good to close the books on those bad deals, so you can move forward confidently into the future, instead of regretting the past.
As a small business owner, you can save money on taxes in a variety of ways. In addition to writing off business bad debts, you may want to consider using IRS-compliant accountable plans to reimburse employee expenses, or sheltering profits in a retirement plan.
So, how about you — which tax deductions do you hate to take? Let us know in the comments.
There are two methods of reporting your business income / expenses to the IRS
The first is the accrual method. In this method of accounting, you declare a sale on the day you invoice the transaction, (and the income from that sale, whether you receive the money or not), thus, you can deduct the sale from your balance sheet if you are never paid by your customer. This is what the uneducated call a write off which it is but in some cases you have paid the sales tax due your state and possibly the quarterly IRS responsibility.
The second method is called the cash method. In this method of accounting, you do not declare a sale until the day you get paid for your invoice. To me, this is a more equitable method of reporting but does not allow a deduction for income never received, thus no write offs; however, your cost of materials, labor, payroll etc. are deducted from the cash received.
At least I recommend that you bring this to your accountants attention.
I don’t think you can deduct bad debt as a loss unless you previously booked the sale as income.
Person A owes bank line abd interest paid 10% for 10 years
All principal is paid in interest.
Bank can still collect from you?
This is an example?
Permission to repost giving you all credit as a read worthy article for my clients.
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As a CPA, there are a few misconceptions presented in this thread. It is correct that a “Bad Debt” may be expensed for accrual basis taxpayers but not for cash basis taxpayers, Why? Because a cash basis taxpayer has never taken the item still sitting in Accounts Receivable into income and paid tax on it. No income … no dedution.
Regarding inventory, TCJA threw a monkey wrench into a lot of this. It gets very technical very quickly but suffice it to say that cash basis, as well as accrual basis taxpayers may avail themselves of this potential deduction. Take a look at the “materials and supplies” regulations. There are de minimis safe harbors for being able to deduct inventory and materials and supplies. Also, the Regulations state that to deduct obsolete and/or worthless inventory you must substantiate that you held it out for sale to the public at a significantly reduced rate and it did not sell.
Regarding the Form 1099-C, you can send a 1099-C but the recipient would probably take the position that it was not a valid debt instrument, and they would be correct. Typically those are sent by financial institutions, credit card companies, postal service, governments and the like. But don’t send a 1099-C just to be mean … although it would feel really good.
Beware of 1099’s. You will owe workman’s Comp. on those. Insurance Company Audits will assume that
those were wages paid out to uninsured personal or companies. You will not win.
If you owe financial institutions and paid 10 % interest for many years. Can they sell the debt and collect money from you?
What about financial institutions claim to IRS bad debt too?
Thank you for the comment! The author, Gene Marks, has provided a response to your question. See below.
Sorry, not sure I fully understand this question. Financial institutions resell debt to 3rd parties all the time. That doesn’t change your treatment of that debt for tax purposes. – Gene
Thank you for this tip. I am a Family Physician in solo practice. I know I cannot deduct the difference between what I charge and the amount the insurance companies pay me, but it never occurred to me to write-off the bad debt when patients don’t pay their portion of the bill. Does this apply to me as well? This could be game-changing for my small business!
Hi Carla! Thank you for your comment. Gene Marks, has provided a response for your question below:
You should be able to deduct any uncollectible receivables as long as you’ve recognized these amounts on your tax return as revenues in the past. If that’s the case then you’ve previously reported too much revenue to the IRS (no cash, no income, right?) and if the amount is not collectible you should get the money back by taking a deduction. – Gene
Actually, if you read the regs re: sending a 1099-c for cancellation of debt, the sender MUST be a financial institution. Accordingly, the letter to your debtor to the effect of ‘If you don’t pay we’ll tell the IRS…” contains a little white lie, as you can’t do it unless you’re a financial institution. Found out the hard way….
I am not an accountant or a CPA and I could be wrong about this, but I spent more hours than I care to admit with my CPA discussing how at least QuickBooks handles inventory, receivables, and payables on a cash basis. From QBs perspective, I have learned that the expense of your inventory and even any inventory related invoices which have been billed, but not yet paid by a customer are NOT recognized on a cash basis until the payment is actually received. This means even the expense paid on the cost of good is not recognized until payment arrives from the customer side. Obviously that’s not the case in the accrual method.
Going through the process of writing off inventory which cannot be sold and bad debt which cannot be collected most definitely impacts the bottomline for a business that operates on a cash basis due to the expense incurred in said inventory. If nothing else I learned that every business owner really needs to have a hands on approach with understanding their books and the pros/cons of accrual vs cash basis.
Cynthia if you are cash based, all expenses go against you profits so it is already a write off. It is the lost income that is really at question. They didn’t pay you for X months, can you 1099c them for the storage up to the auction, I would think so.
I am a Mini-storage facility on cash basis accounting. Every year we have clients who skipped out and did not pay for the rent. They leave the items which may get 35.00 on an auction. The ad, required by law, costs me on an average of $50.00. You can see where I am going with this – net loss for rent unpaid and going through the eviction process which eats up another month of rent. Is there any relief for this type of bad debt?
Jim sorry to say you may be incorrect regarding the disposal of bad inventory. It is a write off for cash basis taxpayers, as cash basis taxpayers record on their taxes the inventory value at the end of the year and if this inventory is not there at the end of the year the value would be lower and thus you have a higher cost of goods sold and in reality you are writing off this bad inventory.
regarding bad debts, yes it only applies to accrual basis taxpayers. Regarding 1099’s yes you should issue a 1099-c to the people who did not pay. a 1099-c is a cancellation of debt. these are used frequently by banks for people who did not pay back loans and their debts were cancelled. this form will hit the person who did not pay for the items or service in the pocket book with the IRS as they actively pursue these people.
“I have a quick question on the bad debt. Is there a process whereby you can send the customer a 1099 so they have to show it as income?”
I’m not sure I understand the question. 1099’s are normally sent to outside vendors/contractors for work performed. There are also 1099’s for interest.
The customers that didn’t pay that you write off…..send them a 1099!
I have a quick question on the bad debt. Is there a process whereby you can send the customer a 1099 so they have to show it as income?
This is true. If like most small business you file your taxes and base your income on the cash basis of accounting these losses have no value other than psychological. Even if you operate on the accrual basis at year end your accountant adjusts for cash and that is used to calculate the pass through income you declare as an LLC or LLP. I do agree that getting long running non collectibles off tje AR Aging report helps you focus on the ‘now’ as opposed to feeling bad about the ‘then’. The charitable donation angle on obsolete inventory is a good idea but with the new tax rules check closely with your CPA to make sure there is a desuction at all.
Jim Kublin is spot on
Jim – that would be correct. This only applies to accrual basis taxpayers.
Thanks for your feedback, Michele!
If I am correctly remembering what my CPA told me, writing off bad debt and unsalable merchandise/inventory only applies if the company is on accrual basis as you have already paid tax on the uncollected money and declared the inventory. If on the cash basis you can not deduct either as you have already deducted the materials and have yet to collect and deposit the receivable.
Check with your CPA or tax advisor.