Writing off bad debts is always an inevitable part of any business operation. Whether one likes it or not, there are points in business when you are forced to write off a debt, especially when a client fails to pay for a service rendered. A typical case could be where you agree with a client that you will undertake a service at an agreed fee only for the client to fail in meeting his or her side of the agreement.
Writing off debts in a business needs a business operation that is genuinely honest. Your accounting needs to be spot on and you must keep good track of any profits and losses. If you incur a loss of $1,000 when using the cash basis model of accounting, it is only logical to say that you cannot deduct a loss twice. This means that you will not report a sale because the value of the sale or service you have given is zero.
On accrual basis, you only have the sum lost recorded in accrued revenue, thereafter you write it off. The difference in this case is zero.
For example, assume that you had provided the service based on a contract worth $2,000, and had hired somebody to do it for let’s say $600 while using office equipment worth $400. These expenses you incurred while undertaking the contract will be deducted from the $2,000. In this case, it means you might have had a profit of $1,000. The IRS does not allow anyone to deduct their profits from a bad debt. Your taxable income would have been $1,000 but in this case, it is a loss of $1,000 but you cannot deduct it from your taxable income.
In any contract, say one involving offering a service, you must’ve spent time. If you had spent a total of 2 hours while your hourly rate is $200 per hour, it means that you might have walked away with $400. The next mind boggling question that you might ask is; how do you treat the $400? You cannot write off the value of time that you spent working on your contract.
IRS does not recognize time that anyone spent doing a job for a client. If you incur bad debts with your time, then you are the sole bearer of the losses that you have incurred. The same principle applies in cases where individuals might have chosen to volunteer their services in a community project. The value of time you spend in services means nothing to the IRS. The IRS will only consider the value of the supplies that you might have used to perform such services. For example, the cost of gas that you used in the vehicle used while engaging in a volunteer service delivery.
Bounced checks that are never redeemed by clients should also be treated as bad debts using the same procedure. When using the accrual accounting model, the same procedure of writing off bad debts applies. For sole proprietors or those who are filing tax returns for corporate businesses, your bad debts will be handled in Schedule C when you are filing tax returns.