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Your new business has a major problem ― some of your clients have not paid their bills. You let it go for awhile, but now the unpaid debt is jeopardizing your small company’s future.
What should you do?
The first thing you need to do is ascertain when the client intends to pay its debt. You cannot put your company into a financial hole by continuing to sell your product to a client who is not paying for what it bought.
Don’t be shy. Introduce late-payment penalties to improve the clients’ incentives to pay on time. You are a for-profit business. You have a right to be paid for the product and services you provide. Don’t let clients think late payments are OK; that’s a slippery slope. If you kept up your end of the transaction by delivering what you promised within the time you promised, you have a right to expect the same.
The IRS says debt becomes bad when you have tried to collect it unsuccessfully after a reasonable period of time. In true IRS fashion, it doesn’t define what “reasonable” is. That’s why it’s a good idea to spell out your payment terms in advance, so your customers understand them. For example:
Payments are due within 15 days
Payments made within 7 days receive a 5% discount
A $25 late fee occurs after 30 days
Unpaid invoices 60 days or older become bad debt and might be written off, reported to credit agencies and/or sold to collections agencies
You can reduce your tax burden by deducting your bad debt expense from your taxable income, but your bottom line will be helped more by avoiding or collecting bad debt than writing it off. Reducing your bad debt has almost immediate dividends, while you can’t reduce your tax burden until you file your tax return.
For large clients, check their references. What are their reputations for paying on time? Even more importantly, check their credit histories. The major credit rating organizations (Experian, Equifax, Transunion) offer business-to-business credit checks for nominal fees.
Maintain a cash reserve fund that allows a small cushion in case a major customer fails to pay. Companies that are in growth stages might find this difficult, yet you’ve got to protect yourself so you don’t come up short paying your suppliers.
Clearly communicate your payment terms.
Business owners can write off bad debt expenses if they use the accrual method of accounting but not the cash method. Accrual method reports income when it is earned, while the cash method reports income when it is collected. In other words, you can claim a tax deduction for business income that was listed as accounts receivable or notes receivable in your accounting books, but you can’t claim a tax deduction for cash that you never received.
Although the most common form of bad debt is in unpaid customer balances, loans to clients and suppliers can also become bad debts. Sole proprietors should deduct business bad debt from the income on their Schedule C returns. Other small businesses should deduct the debt from the income on their business income tax returns. Your attorney and accountant can guide you through this process; both will tell you to keep meticulous records regarding attempts to collect.