Today, millions of Americans are self-employed with their own one-person businesses. In fact, according to the Bureau of Labor Statistics, one in nine American workers is self-employed; other estimates place the number as high as one in six. Being self-employed can be a great way to earn a living. However, it does have its down sides. One of these is the sad fact that many self-employed people have trouble getting paid by their clients. Some hiring firms feel free to pay outside workers late; some never pay at all.
If you end up with a deadbeat client who refuses to pay you, can you at least deduct the amount you’re owed from your taxes as a bad debt? Unfortunately, the answer is usually no. There are three requirements that must be satisfied to deduct a bad business debt. You must be able to show that:
- the debt is a bona fide business debt
- it is a worthless debt, and
- you suffered an economic loss.
If you are self-employed and sell personal services, you will be able to satisfy the first two requirements with most business debts. The problem will be showing the third.
A Bona Fide Business Debt
A bona fide debt exists when someone has a legal obligation to pay you a sum of money. A business debt is a debt that is created or acquired in the course of your business or becomes worthless as part of your business. Your primary motive for incurring the debt must be business related. Debts taken on for personal or investment purposes are not business debts. A debt incurred by a client to whom you provide your services is a bona fide business debt.
A Worthless Debt
A debt must be wholly or partly worthless to be deductible. A debt becomes worthless when there is no longer any chance that the amount owed will be paid back to you. You don’t have to wait until a debt is due to determine that it is worthless, and you don’t have to go to court to try to collect it. You just have to be able to show that you have taken reasonable steps to try to collect the debt or that collection efforts would be futile. For example:
- you’ve made repeated collection efforts that have proven unsuccessful
- the debtor has filed for bankruptcy or already been through bankruptcy and had all or part of the debt discharged (forgiven) by the bankruptcy court, or
- you’ve learned that the debtor has gone out of business, gone broke, died, or disappeared.
An Economic Loss
You are not automatically entitled to deduct a debt because the obligation has become worthless. To get a deduction, you must have suffered an economic loss. According to the IRS, you have a loss only when:
- you have already reported the money owed as business income
- you paid out cash, or
- you made credit sales of inventory that were not paid for.
Unfortunately, if, like most self-employed people, you’re a cash basis taxpayer who sells services to your clients, you don’t report income until you actually receive it. As a result, you don’t have an economic loss (in the eyes of the IRS) when a client fails to pay. Thus, you can’t claim a bad debt deduction if a client fails to pay you.
Example: Bill, a self-employed consultant, works 50 hours for a client and bills the client $2,500. The client never pays. Bill is a cash basis taxpayer, so he doesn’t report the $2,500 as income, because he never received it. As far as the IRS is concerned, Bill has no economic loss and cannot deduct the $2,500 the client failed to pay.
The IRS strictly enforces this rule (harsh as it may seem). Absent the rule, the IRS fears that businesses will inflate the value of their services in order to get a larger deduction.
Accrual basis taxpayers, on the other hand, report sales as income in the year the sales are made—not the year payment is received. These taxpayers can take a bad debt deduction if a client fails to pay for services rendered, because they have already reported the money due as income. Therefore, accrual taxpayers have an economic loss when their services are not paid for.
Example: Acme Consulting Co. bills a client $10,000 for consulting services it performed during the year. Because Acme is an accrual basis taxpayer, it characterizes the $10,000 as income on its books and includes this amount in its gross income in the year in which it billed for the services, even though Acme hasn’t actually received payment. The client later files for bankruptcy, and the debt becomes worthless. Acme may take a business bad debt deduction to wipe out the $10,000 in income it previously charged on its books.
There’s no point in trying to switch from cash basis to the accrual method to deduct bad debts. The accrual method doesn’t result in lower taxes—the bad debt deduction merely wipes out a sale that was previously reported as income.If you're a cash basis taxpayer (like most service providers), then you never reported the extra income that turned into a bad debt so both taxpayers end up in the same position taxwise. So even though it may sound like it's a disadvantage that service providers can't deduct these losses, the deduction really only serves to make sure accrual taxpayers are not paying taxes on income they earned but never received.
Most deductible business bad debts result from credit sales of inventory to customers. When you sell goods to customers, you get to deduct the cost of all the goods you sold during the year. This is true whether you're actually paid for them or not. Obviously, if you're not paid, you won't have income to pay tax on. But you'll still have the deduction for the cost of the goods you sold.