Double Dipping . . . or Why You Can't Deduct Bad Debt

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Double Dipping . . . or Why You Can't Deduct Bad Debt
By Eva Rosenberg, MBA, EA


Folks, this is a rather touchy subject. Say you've done work for a
client
or sold merchandise to a customer who has stiffed you. It's as though
you've been burned twice once for doing the work, twice for not
getting
paid. Well, you may reason, when you go to your tax pro, he or she
will be
able to help you take a deduction for this miserable occurrence and
you'll
recoup some of the loss. WRONG! This is one of the hardest concepts to
explain because people get angry at tax pros when they hear the bad
news.
To understand why it's not so unjust, you need to know the four terms
defined below:


Cash basis accounting  - This is the method most self-employed folks
use.
When you report your income and expenses on your tax return, you do it
by
including only the money you've actually received from customers or
clients
(not amounts that have been billed but not yet collected). Also, you
only
report expenses that you have actually paid (not purchases for which
you
have unpaid invoices sitting in your desk drawer).


Accrual basis accounting  - This method is used by businesses that
sell
merchandise, maintain an inventory, and have unpaid purchases that
exceed
their Accounts Receivables. Working on an accrual basis means that
your
income, for tax purposes, includes all your sales even if you haven't
collected the money for them yet (if you have Accounts Receivable).
You
report your expenses the same way by deducting all the invoices for
everything that you have received, even if you haven't paid yet.


Accounts receivable - Invoices you have sent clients or customers that
have
not yet been paid.


Accounts payable - Invoices you have received but not yet paid.
(Credit
card debts are not included. They're loans. Items purchased with
credit
cards are immediately treated as expenses or equipment purchases.)


Bad debt problems arise with businesses that operate on a cash basis,
which
is the kind most self-employed folks run. Many generate income by
selling
services, time, or advice. Since small businesses tend not to have a
great
deal of credit with merchants, you must pay all your bills when they
are
presented (or within 30 days) if you want maintain your credit. As a
result, you rarely have many outstanding accounts payable.


Usually, self-employed people have more accounts receivable, often
outstanding for 90 days. or even more. The good news is,  if you
report
income on a cash basis, you don't have to report all your billings
until
your customers pay you. Taxes are only paid on that money once it
comes in.


Now, come the end of the year you realize that the client for whom you
gave
up your evenings and weekends for a month is never going to pay. They
owe
you about 4,000 and you want to take a bad debt deduction on your tax
return.


Think about this carefully. How do you take the deduction if you've
never
reported the 4,000 in income? If you reread the definition of cash
basis,
it may help.


Say your friend Roberto takes the deduction. How does he do it? Since
his
business is run on an Accrual Basis, he reported all his invoices.
Roberto
reported the 4,000 in income and now he can take the deduction for
bad
debts. For you to be able to take a deduction for bad debts, you would
have
had to report the billing in your income first. Do the math (4,000 -
4,000 = 0). Since the net effect is 0, why bother reporting the bad
debt
at all? In fact, including bad debt on a tax return is an audit flag.
Since
most people who report bad debts do it erroneously, the IRS is almost
assured of free money if it audits the return.


Even if the final result of the audit is a "no change," the cost for
the
audit representation can exceed 2,000. After all, the IRS won't look
solely at the bad debt. They'll look at the whole business return and
investigate any questionable items under travel, entertainment, auto,
and
other categories. Where does this leave you? Don't push for things you
don't really want. Sometimes, getting nothing is better than taking a
deduction.

=====

Bio: Eva Rosenberg, MBA, is an Enrolled Agent in Encino, California. Her
practice focuses on small business, non-filers, and problem tax audits.
Rosenberg is the author of the popular:
TaxMama's Secrets:Ten Businesses to Start Online Without Spending One Thin Dime
http://secrets.taxmama.com/

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