good riddence to a bad client.
November 17, 2006 10:23 AM   Subscribe

What are the tax consequences (benefits and/or detriments) to a business when a customer refuses to pay. Hey look, theres

A long time customer (been a customer for about 4 years, but not a good customer*) refused to pay an invoice that was for a project that took around 50 hours to complete over the month of October. The project was all labor/creative. No tangible products involved.

Before the project commenced I provided a quotation that he signed and agreed to. In fact, the total of the invoice was LESS than the quoted price.

The project was completed satisfactorily and the customer signed off (literally) on the final results on Oct. 30.

I sent out my invoice on Nov.1 and the customer had 30 days to pay in full, as usual.

This morning, he called me and said that the price was too high and he refused to pay any of it. He then added, "...send me to collections if you want". He brought up collections angle, not me.

Now, I have had to send people/companies to collection in the past (I wouldn’t do so until 90-120 days), so that is not an issue for me. If the money were collected, it wouldn’t be until well in to next year.

What I am wondering is this:

I (my company, an S-Corporation) did not receive the payment and it cannot be listed as income or monies received therefore I have no 2006 tax liability on said payment. Through not paying his bill, this customer not only denied me compensation for the time spent, he robbed me of 50 hours of time that I could have spent performing endeavors that could have been directly or indirectly profitable.

My federal taxes are usually very simple. I don't really get too creative on deductions. Income-expenses=profit. Pay taxes.

Are there any federal tax avenues deduction-wise or credit-wise that I may be able to take advantage of on this no-payment?

Extrapolated further, what if someone I had only one client, for whom work was performed all year who then refused to pay at the end of the year?

*the loss of this customer will not hurt me or my business in any way. They needed their hand held on every thing, required a TON of attention but didn’t do any considerable volume to be missed.
posted by sandra_s to Work & Money (15 answers total) 1 user marked this as a favorite
I file Schedule C rather than as an S-corp, but this strikes me as a boon because there's no income to be taxed... and you can write off whatever went into the project's development. It seems that not paying this tax is a windfall in itself. The client is the one stuck with the tax liability on that unspent money. Again, I'm just a Schedule C filer... help yourself to some grains of salt.
posted by rolypolyman at 10:54 AM on November 17, 2006

IRS Publication 535: Business Expenses, Chapter 11: Business Bad Debts.

It sounds like you're using the "Cash Method" of accounting and will not be able to deduct anything. But, I'm not an accountant and definitely not yours, so read the link and consider speaking to a real live accountant.

If you were able to deduct the invoice as a bad debt and used the accrual method, you'd end up recording the relevant revenue and expenses as they accrued and then deducting the amount of the invoice as a "bad debt expense" later on. The result is that the revenue and bad debt expense cancel each other out and you're left with the expenses linked to that revenue, so your taxable income would've been reduced by the amount of the expenses. Under a cash method, you pay for the cash expenses and record them as you pay, but since you never receive payment you never record any revenue for the sale and have nothing to write off as a bad debt. You still end up with taxable income reduced by the amount of cash expenses. Under either accounting method, I don't see an obvious way to recapture any benefit from time or profit lost. Of course, if you had billed for labor at an hourly rate and paid cash (or accrued accounts payable) to an employee or outside contractor, that would've pumped up your expense line.
posted by mullacc at 11:04 AM on November 17, 2006 [3 favorites]

Schedule D - Capital Gains and Losses. Write it off.
posted by JayRwv at 11:08 AM on November 17, 2006

Schedule D is for investments, not business expenses.
posted by mullacc at 11:22 AM on November 17, 2006

Small claims court is often more effective than collections if the state you are in has a small claims threshold more than your invoice amount. Also, a complaint to the Better Business Bureau and/or a workman's lien on his physical property will often get attention and result in payment.

Your actual expenses during the effort are deductible, but uncollected invoices aren't. Of course, you aren't claiming the invoice amount as income until you get paid, so there's nothing to deduct against.

If you do a small claims action, have him served during business hours.... it maximizes the embarrassment factor.
posted by FauxScot at 11:24 AM on November 17, 2006

You should have an accountant and use an accrual method of accounting.

But generally bad debts are considered an expense.
posted by bitdamaged at 11:29 AM on November 17, 2006 [1 favorite]

You would list this as a bad debt only if it was previously included in calculating your taxable income or quarterly sales taxes. I gather that has not happened here, so in essence the client screws you two ways: on income and on time. Any expenses you incur trying to recoup that loss (i.e., legal fees) *might* be deductible. Your best bet is to consult with an accountant.

The small claims court route would be your best bet for trying to recover the money owed to you. But since the outcome there is seldom in favour of just one side in that kind of dispute, you'd likely be just getting the best satisfaction knowing that you're taking up their time when they could otherwise be screwing over somebody else.
posted by runningdogofcapitalism at 11:56 AM on November 17, 2006

It's not a bad debt... it's an unpaid invoice.

A bad debt would be me loaning money out, decreasing my cash account. If it didn't get repaid, I could deal with this as bad debt. That happens farther down the income statement.

Regardless of cash or accrual basis, she did not loan this entity money, she performed unpaid work.

All of this happens on the first few lines of the income statement (net sales = gross sales - returns and allowances for uncollectibles). She simply does not report the uncollectible invoice as income, wihch is obviously is not until it's collected.

She does get to deduct the actual expenses associated with the work, but one of those is NOT her time. Subcontractor expenses fall in this category, as do any other expenses she actually paid out or incurred as a result of performing the work.

It isn't bad debt.
posted by FauxScot at 11:58 AM on November 17, 2006

I disagree, runningdogofcapitalism.... my experience is that if I deliver a service consistent with a written proposal, (or verbal), I've won every time in small claims court... 4 of 4.

She quoted the deliverables, the rate, terms, etc. and the buyer is liable if she met her end of the deal.

The only problem is that most small claims stuff is appealable, but goes to civil court in that case, where it becomes more expensive to everyone.

I do think it's important to develop the experience of doing this, as it happens a fair amount to the lone eagle creative worker and one needs some arrows in the quiver for the next time.
posted by FauxScot at 12:02 PM on November 17, 2006

A bad debt would be me loaning money out, decreasing my cash account. If it didn't get repaid, I could deal with this as bad debt. That happens farther down the income statement.

This is egregiously wrong. You've latched on to the word "debt" and ascribed meaning to it that is not appropriate in this circumstance. What the OP describes is exactly what is meant by "bad debt" when used in the operating sense (as opposed to financing sense). If the OP were using accrual accounting, she would've increased her Accounts Receivable when she issued the invoice. If that AR is not collectable, it becomes bad debt. Large enterprises automatically assume that a portion of their sales will become un-collectable and maintain an "Allowance for Bad Debts" reserve against which actual bad debts are written-off. Those using cash accounting or that do not regularly have issues collecting AR may just write-off bad debts directly as they occur.

If you entered into a loan agreement with another party and that party failed to pay, it wouldn't fall under "bad debt expenses" as that term is used in this situation. It would more like fall under investment gain/losses and, you're right, it would be recorded further down on the income statement.

Schedule D - Capital Gains and Losses. Write it off.

I claimed this was wrong previously, I still think it is, BUT the IRS does include un-collectable trade receivables under its definition of Capital Assets. But that must refer to one-off scenarios where Schedule C isn't used. Bad debt normally goes in Schedule C (pdf) with other business expenses.
posted by mullacc at 12:42 PM on November 17, 2006

Schedule C does not apply. OP is an S-corp, not a sole proprietor. S-corps file form 1120S and any profit/loss filters down to the shareholders' 1040. No schedule C.

There is a lot of bad advice in this thread. People are mentioning GAAP ("generally accepted accounting principles"), whereas the poster questioned the tax consequences. Tax accounting and GAAP accounting are totally different animals. For instance, allowance accounts are perfectly acceptable under GAAP--the IRS only allows the actual amount written off as uncollectible.

Bottom line is you really should be consulting an accountant.
posted by AstroGuy at 1:09 PM on November 17, 2006

There's a lot of confusion above. In general:

--if you're using the CASH METHOD of accounting, you haven't received the cash, so don't have to pay taxes on the money.
--if you're using the ACCRUAL METHOD of accounting, you have accrued the income (and therefore have to pay taxes on it), but you can probably report it as a bad debt, exactly cancelling the amount of income.

Either way, you shouldn't end up paying taxes on the money until you actually collect it.

(You should take the guy to small claims court, of course. And immediately, don't wait 90 days - serve him the papers next week. Jerk.)
posted by jellicle at 1:22 PM on November 17, 2006

AstroGuy: I hope you weren't directing that at me. My original comment had nothing to do with Schedule C vs Schedule D or any 1040 nonsense. I only reacted to someone else's assertion that bad debt was a Schedule D item, when it is actually a Schedule C item if you were filing that way (which of course the OP is not, but these threads may be read my someone else later on with a similar issue). And I never asserted anything about deducting a provision for bad debt allowance, but only brought it up while explaining why this issue really was about bad debt--that an allowance is created when sales are generated serves as proof that bad debt is related sales/AR as oppose to entering into a "loan."
posted by mullacc at 1:58 PM on November 17, 2006

Either way, you shouldn't end up paying taxes on the money until you actually collect it.

This is true, but I think what the OP is going for is whether they can expense the work done as some sort of operating loss.
posted by bitdamaged at 2:19 PM on November 17, 2006

right, bitdamaged :-)
posted by sandra_s at 7:46 PM on November 17, 2006

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