How to Write Off Unpaid Customer Invoices
After all, unpaid invoices can wreak havoc on your business. An unpaid invoice means you’re not getting paid for the product or services you provided. If you’re like most small business owners, healthy cash flow is a constant concern. Without cash flowing into your business, you can’t make the timely investments you need to keep the business growing.
Therefore, having lots of unpaid invoices on your books means that you may be paying tax on income that you haven’t received. Again, that’s extra money going out the door that could be reinvested in new or updated equipment, fresh inventory, and other necessary expenses.
Of course, you should work on creating a system that minimizes unpaid customer invoices. That said, sometimes it’s unavoidable, so you’ll need to know how to write off unpaid invoices. Before we outline that process, though, first we’ll help you determine whether you’re eligible to write off an invoice.
Determining Your Eligibility to Write Off Unpaid Customer Invoices
The IRS says that if you use cash-method accounting, you generally can’t write off unpaid invoices. This is because when you use the cash method of accounting, you only count revenue when you receive it. With an unpaid invoice, you never receive revenue, so you have no revenue from which to write off the unpaid invoice.
With accrual-based accounting, on the other hand, you would have counted income when you earned it. However, once you determine that you’re not getting paid for that invoice, you need to write it off as a bad debt so you’re not paying more tax than you should.
Qualifying Your Unpaid Invoices as a Bad Business Debt
How you write off unpaid customer invoices will vary based on your tax status. However, even before figuring out the logistics of writing off your invoice, you need to ensure that the unpaid invoice qualifies as what the IRS calls a “bad business debt.”
An unpaid invoice isn’t automatically a bad business debt. In fact, you must be able to prove that the unpaid invoice is worthless, that it’s related to your business, and that you suffered an economic loss. If you can’t prove all three of those things, the IRS won’t consider your unpaid invoice a bad debt, which means you can’t write it off.
Assembling the Proof
The IRS is very strict about writing off bad debt, so you should ensure you have a strong basis from which to claim that your unpaid invoices are eligible to be written off.
To prove that the invoice is worthless, you’ll need documentation that your customer went bankrupt, died, or otherwise won’t pay you. You should also keep track of your efforts, including emails and letters, to collect the invoice. In some cases, it may be smart to hire a collection agency.
Proving that you suffered an economic loss is straightforward if you used the accrual basis for accounting. Still, you should have documentation of the business income you reported that has become the bad debt you’re claiming.
Finally, to prove your unpaid invoice is a business debt, your client must have had a legal obligation to pay you. Any contract documents that you have with your client should be sufficient as proof of a legal obligation.
Writing Off the Bad Debt
Once you’ve determined that an unpaid invoice is worthless, you can write it off when it comes time to file taxes. If an unpaid invoice from a previous year becomes worthless, you’ll have to file an amended return for a refund of the tax you paid.
If you use the cash-based method of accounting, it may feel as though you’re getting the raw end of the deal. In reality, no one wins when unpaid invoices become worthless. If you’re eligible to write off the unpaid invoice, it’s only because you would’ve had to pay taxes on income that didn’t exist anyway.
Hopefully, you can avoid unpaid invoices altogether, but if you are faced with this issue, you can now rest assured that you’re prepared to handle it!
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.