End of Year Tax Planning: Overlooked Deductions (Part 1)


Today, I’m talking about.

Welcome to your last minute 2018 tax planning. Today, I am going to talk about an overlooked tax deduction called the business bad debt. Specifically, we’ll be talking about a business bad debt. What is a business bad debt? So now let’s say, one of your customers comes to you, you provide a service, and then you provide a service, but they didn’t pay you. They say, “Ah! I’ll pay you in 30 days.” You send them an invoice. They didn’t pay. You send them an invoice in 60 days. They didn’t pay. You send them in 90 days. They didn’t pay. Well, what do you do? Well, you can take them to court and try to collect your money, or you might be like, “You know what, it’s not worth my while. I’m not going to collect from this customer.”

A lot of times all we end up doing is, we forget to remove this debt we’re not going to collect from our books, and we end up paying taxes on sales that we did not actually collect the cash for, or we might never collect the cash for. Well, guess what, the IRS does allow you to dock that, the bad debt from your books and as an expense. So, using a specific charge of method, that’s qualified for tax deductions only during the year, which they become worthless. So, it becomes, you can deduct it when you realize that you’re not going to collect. For partly worthless debt, deduction is limited to the amount charged from your books during the year. So it means, you have to charge from your books before you can actually deduct it in your taxes.

Now remember, this applies only Accrual Basis Taxpayer. And I’m going to talk next about what an Accrual Basis Taxpayer is, and why it’s only applicable to them. So, who’s an Accrual Basis Taxpayer? An Accrual Basis Taxpayer is someone that recognize income expenses when all the events that affects the event has been completed. For example, let’s say you sold a pencil to a person A, well, you haven’t collected the cash from the pencil, but person A has received the pencil, so you have the right to collection of the cash.

So, an accrual basis, that event provokes income. So, you haven’t received the cash, but you have income. In the same way, let us say you pre-pay for a service, and you haven’t received the service yet. Well, the cash has gone out. In the accrual basis, that cash, that service will not be recognized yet, because you haven’t received it.

So next, I will demonstrate to you the difference between an Accrual Basis Taxpayer and a Cash Basis Taxpayer. So, remember an Accrual Basis Taxpayer only recognize tax income when the event has happened. Versus cash basis who will recognizes income and expenses when the cash exchanges hands. So, this accrual to cash basis comparison analysis can be downloaded by clicking the link below. So just click the link below, and you can use that to test if your taxable income will be greater under the accrual basis or if your taxable income will be greater under the cash basis.

Because a lot of times by default most people just choose cash basis, or some people choose accrual basis, but you want to be very careful because your choice should based on how you collect your cash. If your cash, if the difference between your Cash Income and your Accrual Basis Income is so great and you make less than $25 million, then being on the cash basis might be better for you, because at least that way, the cash that you have available to pay your taxes resembles what’s on your book versus, let’s say, you’re not collecting you accounts receivable, you have so much inventory. Well, using the accrual basis, you have to pay taxes whether or not you have the cash. So being an Accrual Basis Taxpayer when you don’t have a lot of cash could get you in trouble. So.

Anyway, that’s by the side line. I just wanted to mention that. So, I will illustrate an example, go ahead and download the Excel file below and you can work along with me if you want.

Now, let us take a look at a practical example of accrual versus cash basis. So let us say, it’s the end of the year, you look at your balance-sheet statement, which is where you get this number from, and it says you do a two-year comparison compared to previous year, and then it says, okay, previous year, at the end of the previous year you had $25,000. At the end of this year you had $22,000. You scroll down to your liability section, you see you have $50,000 of unearned revenue or customer for payment. So let’s say your business is structured such a way that customers had to make deposits before you actually get the work done. Well, in the accrual basis that’s kind of not really income to you yet. It’s income that will become income once you perform the service. So those are customer for payments.

And then, let’s say you made sales of $55,000, and during the year, you had customer for payments that you recognize as $78,000. And then you looked at your accounts receivable section, and you’re like, “You know, this $3,000 of this amount, I’m not going to collect it, so you write that up.” That’s your bad debt expense. Then next, you look at your inventory, maybe you didn’t have any inventory, but you had Cost of Goods Sold for $7,200, and then you had total operating expense of $13,200.

So now look at the cash basis and the accrual basis. In the cash basis, your revenue is $105,000. In the accrual basis, your revenue is $55,000. And that’s because mostly comes from the fact that that prepayment is not counted as income. See? Which one is better? I don’t know. It depends on your specific circumstance. Do you get customer deposits? Your income will be less than the accrual basis. You know that’s something to think about. Your expenses, under both is $20,400 ’cause no adjustments were made when there were no prepayments made. But let’s say, you made prepayments, and you had an ending balance of $5,000. See, those prepayments on the cash basis recognized, when it’s an accrual basis, it’s not recognized.

What I would especially like to draw your attention to is the bad debt. Now remember, in the cash basis, we don’t worry about accounts receivable and accounts payable or prepaid, anything like that, we just like, we got cash, it’s income. We paid expenses, it’s outgoing, affect our net income. In the accrual basis we don’t care about those things. We didn’t complete the event. We don’t have an income.

As we can see, also, any accounts receivable, we have recognized in the past, that we figured out this year we’re not going to collect because Sally, she’s out doing her own thing. She’s not going to pay us. And honestly, the amount is too small for me to worry about, because by the time I file little small claims court or hire a collection agency and do all that stuff, it’s too much of my energy. I am too busy growing my business.

I’ll learn my lesson. I am just not going to deal with Sally anymore. I just want to write it off. I can’t, I’ve tried. She’s not going to pay. I’ve done everything I can. She’s not going to pay, fine. I’m just going to write it off. I have a policy. And also, this should be backed up by the policy, and when debt is considered uncollectible. So, I’ll write it off.

Now, we see with the cash basis, I’m not able to do that, because, guess what? I don’t have any accounts receivable. I only recognize income when I get my cash. With the accrual basis, I have that leeway to make those adjustments. So, this is what makes accrual basis a little bit better when you offer accounts receivable, when you have inventory, ’cause take a look here! My taxable income, my net incomes is $31,600 on accrual basis versus $84,600 on the net on the cash basis, Huh. Really? Can you imagine? Nothing has changed. The only thing that has changed the way I recognize my income and expenses.

So, which one do you think is going to have me pay less tax this year? Obviously, I don’t have to tell you it’s the $31,600, and plus, I get to write off my bad debt. So just because I recognize it, doesn’t mean that it’s gone forever, if I can’t collect it. I can’t recognize it. Those are things we often overlook, because at the end of the year, you want to make sure you look at your balance sheet statement to see, “What are my worthless assets?” And accounts receivable is often overlooked. Okay, we just talked about business bad debt. That’s your accounts receivable you consider worthless. Now, let’s talk about knowing business bad debt, you see bad debt deductions just don’t end with the business. What if you borrowed some of your extra cash to someone, and they refuse to pay you back? Can you take a tax deduction once declared the debt is worthless? Now, let’s be careful here. If this is to your family or friend, the IRS might consider that a gift, and not really as a bad debt.

What is considered a bad debt… The borrower should have signed a promissory note, there was interest, there was an agreement. It’s formal. So they promise to pay. So any time you’re borrowing some money, money, make sure they’re sign a note, because that is proof that you actually gave out the loan. So, you call James up like, “James, what’s up now, where’s my money?” James is like, “Alright, I’ll pay you back when I get paid in two weeks. Okay?” Two weeks come, like, “James, what’s up now? Come on, James what’s up?” Then before you know it, you can’t get in touch with James. James has disconnected his phone. You’ve tried, you’ve tried, you can’t get in touch with James, and James is like, “Forget you man, I’m not paying you. You’re like, you can’t even get in touch of me. You don’t know where I am.” So what do you do, is the money gone forever? Not really, ’cause the IRS actually allows you take a deduction for that. So once you’ve established that our debt is worthless, you can actually take a short-term capital loss, on form 8949.

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By |2018-12-06T16:51:58+00:00December 7th, 2018|2018 Tax Planning|Comments Off on End of Year Tax Planning: Overlooked Deductions (Part 1)

About the Author:

With over 16 years of accounting and finance experience, I know what it takes to make your business profitable. However, in my opinion of what really makes me qualified to work with you is my love for using my God-given gift to help people with numbers. I love difficult problems and my business is to be in the business of helping other people achieve their dream/vision/ goal in the most cost effective and productive way. I am very passionate about my clients and take their problems very personally.