Bad debt expenses are debts you can’t collect from customer invoices. This typically occurs if your business delivers products or services to customers before receiving payment. You later find out that these customers can’t pay for the goods or services your delivered due to financial problems, such as bankruptcy or losing a major account.
For example, Smithco Construction pays for 10 tonnes of your premium Acme bricks for $50,000. Smithco Construction, unfortunately, doesn’t pay the invoice for the bricks due to its own financial problems. You are now out $50,000 worth of products your company made with the understanding that the customer would pay for the bricks.
This type of bad debt eats away at your profits and sets back the income you planned for. Not only does your company have to try to make up the difference through the rest of your fiscal year, but you can’t write off the bad debt expenses until tax time the next year. The bad debt hinders your cash flow, and you may have to let some employees go, scramble to find new customers or delay making vital equipment purchases until you make up for that lost income.
How to Write Off Bad Debt Expenses at Tax Time
The Canada Revenue Agency allows you to write off the bad debt expense on line 8590 of form T2125. The CRA does have stipulations to follow before you can write off these bad debt expenses on your taxes. For example, you must make every determined effort to collect the debt. You also must include the debt as income for that taxation year or a previous taxation year. In other words, you declared that $50,000 as income, yet you didn’t receive that income.
If you assign the debt to a collection agency, you can recoup some of the costs of the bad debt expense. Selling your bad debt to an agency means that uncollected invoice immediately becomes a bad debt expense. To account for this, you list the difference between the bad debt itself, say $50,000, minus the amount the collection agency pays you for collecting the bad debt. The fees you pay the collection agency also become part of the bad debt expense. For example, a collection agency gets $25,000 of that $50,000 bad debt, which means you can write off $25,000 of that bad debt expense if the agency collects it before the end of the same tax year. Otherwise, the $25,000 you collect in the next tax year becomes income for tax purposes.
Don’t automatically write off these uncollectible debts as bad debt expenses. In the event of a bankruptcy, you have the right to collect the money owed after the court liquidates the assets of the bankrupted customer. However, if there is no chance that your business can get its money back, write off these uncollectible debts as expenses. A high bad debt expense indicates that your business may have an inefficient credit and collection process.
To write off a bad debt on your taxes, you must keep accurate records of your invoices and accounts receivable. QuickBooks Online offers easy-to-use software that informs you of overdue debts while tracking your income and expenses. 4.3 million customers use QuickBooks. Join them today to help your business thrive for free.