An all-too-common error on Schedule C business returns occurs when the business owner takes a deduction for a “bad debt loss.” The writer, editor, researcher, or illustrator performs services for a client and the client refuses to pay, goes out of business, or just disappears. Although you are certainly not happy about this event, you console yourself with the idea that at least you can write off the amount as a tax deduction. Unfortunately, this isn’t the case, when you are a cash basis taxpayer. The lion’s share of Schedule C’s are filed using the cash basis. [For a discussion of cash basis, see my previous blog on the topic].
Why? As a cash basis taxpayer, you only report income when it is received. Since you never received the income (or reported and paid tax on it), you cannot take a bad debt deduction. Too many cash-basis Schedule C’s erroneously show bad debt losses (small and large) and this ups their audit score. Depending on the amount, this error will, at a minimum, trigger correspondence or an automatic adjustment by the IRS and could, coupled with other items on the return, trigger an office or field audit.
If you are on the cash basis and extend services but cannot collect your fee, you cannot claim a bad debt deduction. You have not sustained an “economic loss” even though you were not justly compensated. If, at some future point, you do collect your fees, you would report them in the year received.