Can a cash basis sole prop take a deduction for bad debts? My understanding is that "bad debts" only applies to organizations that use accrual accounting and have therefore already accrued income which they can then deduct if the actual income never materializes.
However, I've run into some folks who argue that you spent the time on it as a sole prop, so it's deductible (I'm thinking that I just have to take it on the chin when self employed).
Thanks,
It is not correct that a sole proprietor myst use the accrual method
to claim a bad debt.
But let's talk very briefly about what miht or might not be a bad debt and let's assume you are on a cash basis since you seem to be.
Case 1. Your client wishes to expand his business and you lend him the cash to buy an office condo. You and he sign a mortgage agreement and file it with the county clerk giving you a secured interest in that property. Client falls on bad times, files bankruptcy and has your mortgage discharged in BK. You end up with nothing but a large unpaid debt.
Case 2: You are a web page designer and contracted with a client to build a web page and spent quite a not of time and effort in doing so. Client decides to abandon his business and walks away. You sue and get a judgement for the contracted amount plus legal costs, but client is still walking and has no assets from which to collect.
Case 1 would seem textbook bad debt, while case 2 is not and you're out in the cold without even any comfort from being able to claim a bad debt.
Had you been on an accrued basis and billed client and reported that billed amount as income, that would be a different situation.
Suppose you lend a customer $5,000 to buy widgets from you. He buys $5,000 worth of widgets. You report $5,000 income from sale of widgets. If he never repays the $5,000, that's a deductible bad debt (assuming the usual requirements about attempt to collect, etc. are met).
Time does not lead to a deduction (unless you've already declared taxable income for spending that time).
Seth
If I were a cash basis sole proprietor, I would not report $5000 in immediate income from the installment sale. I would report payments as they are made. Is this not correct?
So far as I can tell there are three scenarios that are allowed:
Cash basis sole proprietor accepts "business debt", reports payments as revenue only as they are made.
Accrual basis sole proprietor accepts "business debt", reports full amount as revenue, and can later subtract business-associated bad debt from their Schedule C as it becomes bad.
Sole proprietor accepts "non-business debt" (e.g. publically traded bond, deed of trust, etc.) Reports FMV as revenue, and then if it defaults can later take either a capital loss or a bad debt on form 1040 -- no Schdeule C impact.
Steve
That's correct, but it's not my scenario. In mine, you lent the customer $5,000 cash. He bought the widgets, and paid cash (which you had just lent him).
Reports full amount less loss reserve for bad debts as revenue, adjusting the reserve as appropriate.
Yes (barter).
The item received is effectively a personal possession (investment) at that point.
Seth
NOT so fast.
Unless you are in the business of making such loans this is not a business bad debt, deductible on Schedule C. Rather its a nonbusiness bad debt deductible as a short term capital loss on Schedule D.
The worst of it is that doing this results in income subject to SE tax because of the nonbusiness loan and a deduction limited to offsetting capital gains with an excess deduction for no more than $3K a year. With no other capital gains it would take you 2 years to write this off AFTER you've already paid ordinary income tax AND SE tax on the money.
On the other hand, if you extend credit to your customer in the form of providing him with the widgets and letting him pay you later - either in a lump sum or via installments - then you can report the income as collected and defer both income and SE taxes until such time as you actually get the money. You still get the deduction for COGS since you did supply the widgets.
Gene E. Utterback, EA, RFC, ABA
I would think that since the purpose of the loan was to enable the customer to purchase my widgets, and I'm in the business of selling widgets, that makes it a business bad debt. ISTR a court case some years back in which an employee lent money to his employer to keep it going; when the company failed, he claimed a business bad debt. The IRS disagreed. The court ruled that he was in the business of being an employee, and the loan was therefore made to help his business, hence it was a business bad debt.
Seth
Is your Case 1 bad debt business or non-business?
I have a problem with the scenario that Seth presented. If the vendor makes a business loan to the buyer to purchase its product, then I believe the proper tax accounting for a cash basis taxpayer is to book notes receivable and record cost of goods upon shipment. No income can be booked as no income has been received. Income can only be booked when payment on the receivable is made. If the buyer defaults, there is no bad debt writeoff as no income has been reported.
On the other hand, if the vendor makes a loan to someone with no strings attached and the borrower can use their own volition to decide what to do with the funds, and then buys product from the vendor, income can be reported and if the buyer defaults on the loan, there would be a bad debt writeoff. However, it would not be a business bad debt as the loan had nothing to do with a business (assuming that the vendor was not also in the business of making loans).
Not necessarily. The question there is do you normally lend money to your customers as a regular part of your business. The occassional loan to a client doens't rise to the level of lending being the business you're in.
There is more than one such case and the difference here is that without that loan to the employER the employEE would NOT have a job or get a paycheck. It may feel the same but it isn't.
Gene E. Utterback, EA, RFC, ABA
If you are in the trade or business of making loans, business.
Otherwise, even if this is a loan to your client in connection with your, say, advertising business, the loan would not be a business bad debt.
,
I can't unilaterally agree. It will depend on the facts and circumstances.
Extending credit (or a loan) to a client so he/it may remain solvent and do continued business with you/your company clearly has a business purpose behind it, especially if it keeps your own business operating. [Nowhere am I saying that such a move is wise, but the tax laws do not consider the wisdom behind taxpayer transactions. Obviously, such credit must be a separate transaction than a receivable.]
The widgets were sold for cash. The note was received for the loan. Making a loan is not a taxable event.
Cash was received for the widgets. For a cash-basis taxpayer, why does it matter where the customer got that cash?
The receivable is in exchange for the loan. Under that interpretation, it would be very easy to defer income by lending money.
That's the treatment for an installment sale.
Seth
Doing what I think is necessary and appropriate to assist my customers in buying my widgets is part of the business I'm in.
Without that loan, the customer would not have made that purchase and I would not have made that sale. Is it necessary to preserve my _entire_ business or only some part of it?
Seth
I will just repeat what I said and ask that you review the tax accounting rules when you finance a sale. A cash basis taxpayer does not book income if the sale is financed with a note to the seller. If there is no income, there is no bad debt writeoff if the buyer/borrower defaults. It is not a cash sale.
Seth appears not to be aware of the collapsible transactions doctrine.
Will the IRS collapse transaction that result in lowering taxes?
If the amounts were only approximately equal (or even not that close, e.g. lend $3K and a sale of $5K), would the transactions still be collapsible?
Seth
If you are in business as a cash basis taxpayer, and you finance the sale of your product, tax accounting says that you only book income for the cash you receive. The balance is a receivable. If you sell product for $5K, receive $2K and finance the remaining $3K, you book $2K of gross income, record your COGS when you ship and record $3K of a receivable (notes or accounts depending upon how you financed the sale).
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