*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)!!