When Your Client Does Not Pay: Why it's Not a Tax Loss

accounting

One of the most frustrating parts of being a business owner is when you have provided a service to your client and they do not pay. It feels wrong. When we aren't paid we often look for a silver lining such as a tax write-off to ease the pain. Although I use a client example here, the same is true for customers or patients.

Unfortunately, although this is a loss of income for our business, it does not reduce our tax obligation. To better understand why this is and how it works, we first must understand the two main types of accounting methods: cash and accrual.

Cash vs. Accrual Method

Most small businesses use cash method of accounting. If you were in business last year and are unsure, pull out your prior year return. If you are a sole proprietor or LLC look at your Form 1040, Schedule C, Line F. If you are taxed as an S-Corp go to your 1120S tax form Schedule B, Line 1. Your accounting method will be checked. 

Cash method is simplest and easiest to understand. Under the cash method revenue is recorded when you get the cash and expenses are recorded when you pay the expense.

Under the accrual method revenue is recorded when you provide the service, regardless of whether you are paid before, at the time of service or after. Expenses are recorded when you incur or owe them, regardless of when you pay them. As a result, accrual accounting is more work, complex and usually requires an accountant. 

Both methods lead to the same end result

We are taxed the same regardless of which method of accounting we choose. This is best explained with an example. Let's say you charge each client $100 for your services. You see 12 clients this month and only 10 actually pay you. 

Under cash method accounting you record cash when you collect it so $1,000 is recorded as revenue.

Using accrual method, you would record $1,200 in revenue even though you only collected $1,000. If it was tax time, the accrual method has you paying tax on an extra $200 you did not collect. The $200 is recorded as money owed from clients.

For this reason, if the $200 is never collected, only the business using accrual method is allowed a write-off for the loss. You may have heard the term "bad debt write-off" and that's because the accrual method businesses are writing off that $200 owed from clients that is no longer going to be collected. The debt from the client is "bad." The cash method businesses never recorded that $200.

Once it is evident the money cannot be collected, writing off $200 puts the accrual method business back to $1,000 in revenue, right where the cash method business was in the first place ($1,200 initially recorded - $200 write-off = $1,000 remaining revenue). In the end, they will both only pay tax on the $1,000 collected, not more and not less.

See the additional example that has been added below. 

Pro bono work and reduced fees

In the course of business you may decide to intentionally offer services to some clients for free or at a generously reduced fee. The same accounting rules apply. We need to pay taxes on the income we do receive, nothing happens with the services we provide for free or a reduced fee other than we hopefully feel good about this work. It won't help us in the wallet and it won't help us on our taxes.

Charitable deductions

A business owner may wonder if unpaid services can be deducted as a charitable contribution. The answer is no. Most small businesses are pass through entities (sole proprietors, LLC's and entities taxed as S-Corps) and pass through entities cannot deduct charitable contributions at all. Further, the IRS is clear that contributions of time and services are never deductible, not even on our individual taxes. For more information see IRS Publication 526: Charitable Contributions, go to page 6 for "Contributions You Can't Deduct" and see #4 on the list. 

Product and service example

Here is an example of selling a product which might be easier to understand and then compare it to a service business. Let's say you started a donut shop. You buy the ingredients and rent space for one day, and you know the max you can sell based on your price point is $300 worth of donuts. You spend $200 in expenses to be able to make and sell these donuts. So your max profit is $100. 

You promise most of the donuts to a person you know. You sell $20 worth of donuts to the public, but then this person who was supposed to buy the rest never shows up. The donuts get too old and you can't sell them to anyone else. So there was $280 of lost income opportunity, $20 of revenue and $200 of expenses. 

The taxes need to reflect the economic reality of what actually happened. For accounting and taxes we ignore lost opportunities. We certainly don't want the government to come and tax what we could have made, our max potential, if we never actually saw that money. Likewise, we can't expect the government to give us a deduction for lost opportunities either. Our profit and loss would look like this:

Cash method:
Revenue          $20
Expenses     -$200
Net Loss      -$180

Accrual method:
Revenue        $300
Bad debt      -$280
Expenses     -$200
Net Loss      -$180

Now let's compare this to a service business where our time is what we are selling, and make it so that we have all the appointments but later we aren't paid for our work. This is the situation people most want to take a deduction because they actually did see the clients, spent the time and really, really expected to be paid. 

In this example, we have 15 appointments and each appointment is $20. We see all 15 people so we expect to be paid $300. The cost to rent the space for these appointments was $200. We are out the $200 either way, we have to pay that bill even if we didn't make any money. We just need to collect the money and we will have made our $100 in profit!

Unfortunately, only one of these clients paid. The remaining 14 did not pay. There could be all kinds of reasons, maybe some gave us a credit card that was declined and we can't obtain a new one, we may have agreed to letting some clients not pay because they can't afford it, and we may have tried to collect the remaining payments but been unsuccessful. The profit and loss looks exactly the same as with the donuts above.

Cash method:
Revenue          $20    actually collected
Expenses     -$200    actually paid
Net Loss      -$180     actual money you lost

Accrual method:
Revenue        $300    amount earned
Bad debt      -$280    less amount not collected
Expenses     -$200    actually paid
Net Loss      -$180     actual money you lost

Bottom line

We are in business to make money and when we expect to be paid for our products or services and we do not get paid, it can be difficult to accept. If we could somehow get a tax savings it would be a little easier on us. However, we do need to pay taxes on all the revenue we get and only deduct allowable business expenses. We can be mindful of collecting what we are owed and if someone isn't paying us as agreed we may not want to do business with them in the future.

This is only a brief overview of how accounting works. If you want to learn more and possibly do your own bookkeeping or be able to have intelligent conversations with your accountant, check out my courses and coaching services found here: Simple Profit Store and make sure you've seen the 10 Essential Steps to Start Your Business as well as the other blogs!

 

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