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Small business owners can write off unpaid invoices if they fit the following the criteria: they’ve recorded the unpaid invoices in their accounting system, they’re an accrual-basis taxpayer, and they can prove to the IRS that they’ve taken reasonable steps to collect the invoice from the customer.
Unpaid invoices—as much as we wish they weren’t something we have to consider, we do. You know the drill: You get a new customer, provide a product or service to them, and send them an invoice for payment. And then as you’re doing your books (in your accounting software of choice), you realize that money’s probably never coming. So, can you write off those unpaid invoices?
Accountants who work with small businesses often get questions about whether you can write off unpaid invoices. Small business owners are right to ask because writing off unpaid invoices is possible. In some situations, that is. But it’s not as simple as it sounds to determine whether or not you can write off unpaid invoices in your business taxes. As the owner of your business, there are a few questions you’ll need to answer that will determine exactly whether or not your CPA can write off your unpaid invoices.
And those answers matter because a write-off can affect both your bookkeeping and your taxable income. Similarly, the way keep you track of the invoice can be different for both of those options. (Phew!)
As we go along, we’ll pretend we’re working with an invoice dated 12/5/17 that is paid on 1/15/18, so we can see how the same invoice is treated differently on our books and our tax return.
The first test in determining if you can write off unpaid invoices is whether or not you recorded the invoice in your accounting system. If you prepare and save your invoices using a computerized accounting program like QuickBooks Online or Xero, then the answer is yes.
That’s because when you save the invoice, automated systems add the amount to your books, and the invoice will appear on the reports generated by the system until it’s either paid or written off.
If you prepared your invoice using a program like Word, Google Docs, or something other than your accounting program (and didn’t record it some other way on your books) then the answer is no, because the invoice (and income) won’t appear on your reports. Which means that there’s nothing to write off.
The second test in determining if you can write off unpaid invoices is whether you reported the income on your tax return. Let’s keep going with that example of an invoice created in December 2017 with customer payment actually received in January 2018. An accrual-basis taxpayer would include the amount of the invoice on their 2017 tax return, while a cash-basis taxpayer would include it on their 2018 return.
And if that invoice is never paid by the customer, can you write it off? It depends on whether you’re an accrual- or cash-basis taxpayer.
An accrual-basis taxpayer can write of the unpaid invoice because they paid tax on the amount of the invoice on their 2017 tax return. If they don’t receive the payment from the customer, they can deduct the amount of the invoice as a bad debt expense in the tax year that they write it off.
However, a cash-basis taxpayer cannot write off the invoice because the amount of the invoice was never included in their taxable income. Remember that a cash-basis taxpayer only includes the income when they receive the payment from the customer. If that never happens, the income is never reported and no deduction for a bad debt is needed.
So, wait a minute! Does this mean that you may need to write off unpaid invoices on your books and not on your tax return?
Actually, yes! If you use an accrual-based accounting system and file a cash-basis tax return, you’ll need to record a write-off to adjust the reports in your business’ bookkeeping, but you won’t write it off as a bad debt on your tax return. Remember, we can’t deduct a bad debt on our return unless we previously reported the income on an earlier return.
The last test in determining whether you can write off unpaid invoices is considering the likelihood that the invoice will be paid in the future. IRS guidelines say that in order to make a business tax deduction on the amount of the unpaid invoice as a bad debt, you must have previously reported the income on a prior tax return and be able to prove that you have taken reasonable steps to collect the invoice from your customer.
There isn’t a magic number of days that the invoice is past due that makes the invoice eligible for write-off, either. According to the IRS, it’s the facts and circumstances surrounding the situation, plus whether the debt on the invoice is considered worthless, that determine whether you can write off the unpaid invoice.
In fact, the invoice doesn’t even have to be past due for you to write it off as long as you can prove that it was worthless when you wrote it off. This could happen if a customer abruptly goes out of business or tells you flat out that they have no intention of paying you.
You’re required to take reasonable steps to collect unpaid invoices before you write them off. This could include making phone calls to your customers, sending letters, or even hiring a collection agency to collect the debt.
If your customer’s payment habits are affecting your own cash flow, you could consider using invoice financing to help minimize the possibility of write-offs. See a little more about how invoice financing works, and check what you’re eligible for now if you’d like.