*I am not a tax professional. This is meant to be educational and NOT a recommendation. Each personal situation is different and there’s a lot of grey area in self-employed deductions. If you have questions (even just little ones) … talk to a tax expert.*
I always saw ‘bad debts’ on the list of deductions my accountant sent me and thought… well… all my debts are bad… can I just write them off?
No, silly. That’s not what bad debts are at all.
Bad debts happen when someone is supposed to pay you… but then never does.
Sounds pretty simple, but it actually brings up an important question: why would you be claiming income on your tax return that you didn’t actually receive?
Answer: The Accrual Method – the way you SHOULD be reporting income
There are two ways to record income in business: the accrual method and the cash method.
The cash method means that you only report income when it actually shows up in your bank account. Which makes sense.
The accrual method means you have to report the income as soon as it’s earned, whether it’s paid or not. So when I finish a gig and that contract is complete – I have to report that income … even if they haven’t paid me yet.
The CRA wants businesses to use the accrual method. They only let a few kinds of people use the cash method (mainly self-employed commissioned salespeople). If that sounds like you… cash away…. otherwise… it’s the accrual express.
Source: CRA website
So how do bad debts happen?
Bad debts happen when you report income (like you’re supposed to under the accrual method) but it never gets paid.
The government is going to be a jerk and make you pay tax on money you never got…. so you can deduct it as a ‘bad debt’.
I think this piece on blogger business expenses sums it up quite nicely.
On bad debts:
“This is if someone owed you money but you never got paid, and you want to claim the income tax of your income back.
You won’t actually get the $200 you were owed paid by the government instead, but you will avoid having to pay income taxes on the $200, as you invoiced the customer and have to file it as part of your gross income.”
When does a ‘late payment’ become a bad debt?
This is where things get a little fishy. Just because someone doesn’t pay you right away doesn’t make it a bad debt.
Using the accrual method you WILL have to pay tax on money that you haven’t received yet.
But when the day comes that you become reasonably sure that you’re never going to actually get that money – it becomes a bad debt.
This is one of those… if you think you have one… you should talk to a tax pro.
But here’s hoping everyone always pays you on time! #rosecolouredglasses
Have you guys ever dealt with bad debts? Share your stories (and what you learned)!!
Thanks for the link back, I’m glad you found it helpful. What HP said is true. It is really all up to interpretation because it depends on when you think you might get paid, if they’re just late, etc.
Of course if you do get paid, you’ll have to claim the income accordingly…
Loved your piece! A really great breakdown. I actually linked the same piece as well in today’s daily deduction – the Capital Cost Allowance.
For the last point, it depends a fair bit on interpretation and circumstances (to my understanding, I’m not an accountant, advice not dishwasher safe, etc., etc.). Here’s a paragraph from the CRA (may be out of date):
“There are no specific conditions that must be met before a debt may be classed as a bad debt. Such a decision should be made only after determined efforts to collect the debt have been unsuccessful or there is clear evidence to indicate that it has in fact become uncollectible. If a debt is merely doubtful of collection, it should not be claimed as a bad debt but should be considered for purposes of a reserve for doubtful debts. The fact that a recovery is made after a debt is written off does not negate the correctness of a claim for a bad debt if the recovery could not reasonably have been foreseen at the time the debt was written off.”
So for example, if I’m at Word on the Street and someone picks a book up and flips through it and says “I’m going to buy this, I just have to get some cash from my wife,” and then walks off, book in hand, and never comes back to pay, then I’m calling that a bad debt (well actually I’d call it theft, but the point is that there isn’t even a hard and fast rule on timing — if you can recognize it right away, it’s a bad debt). Conversely, if I’m working with a massive, bureaucratic institution, it may take months and months and months for an invoice to get paid. Even if I’ve been waiting 150 days (true story), I’d be hesitant to mark it as a bad debt because I believe they’re still likely to pay and just delaying things.
To my mind, if you expect, based on your typical customers and the way your business sector typically works, that you’re never getting paid on a debt, then count it as a bad debt. If it does get paid you can reverse it the next year by including the repayment in your income. If you do that more than a few times, then you need to be stricter in your definition of bad debt (you’re allowed to count a debt as bad and reverse it if the repayment could not be foreseen — but you can’t churn money through the “bad debt” line as a way of deferring income). Lots of room for interpretation with this line.
Brilliantly broken down. It’s another one of those tricky areas… thanks for fleshing it out a bit (read: a lot)
You’re awesome.