As a business owner, what’s worse than getting paid late? That’s right, not getting paid at all.
No matter how hard you try, there’ll be instances where customers won’t clear their dues. They may declare bankruptcy, leave town, or even disappear without a trace. At times, personal loss or even a customer's demise can make it impossible for you to collect payments.
Unpaid invoices, accumulated over time, can hurt your finances and also affect your taxable income. And while you can take steps to clear an overdue payment, an outstanding invoice that just won't get paid should be accounted for in your books. This practice will help save on taxable income as well as keep your business afloat during uncertain times.
In this article, we share four handy steps to account for unpaid invoices and avoid cash flow problems. Read on to check if you're eligible to get tax relief for an overdue payment.
Traditionally, accounting is of two types: cash based and accrual based. The difference between the two is how revenue is recorded. Cash accounting recognizes revenue only when you receive money from a client, while accrual accounting records revenue as soon as an invoice is generated.
According to the Internal Revenue Service (IRS), if you use cash-based accounting, you can't account for unpaid invoices, as you didn't receive any money in the first place. But if you use the accrual method and haven’t got paid, you can show the invoice to prove the due amount and file the outstanding invoice under bad debt expenses.
Be consistent with your accounting method. Opt for accrual-based accounting so it’s easier to submit proofs for unpaid invoices during tax filing.
If you're eligible, the next step is to check if an overdue invoice qualifies under bad debt deduction. As a rule, you should meet the following conditions to qualify:
You must have a record of the unpaid invoice in your accounting software. Most accounting systems automatically save invoices as part of their bookkeeping feature.
You must have reported the invoice amount on your tax return. With accrual-based accounting, you can report the overdue invoice amount when filing tax returns despite not getting paid.
You must prove that the unpaid invoice is worthless and has caused economic loss for your business. In other words, you have to prove the customer hasn’t paid despite repeated collection attempts.
Use an invoice management solution to ease the qualification process. The software can automatically determine an appropriate expense category for any outstanding invoice.
The IRS is strict about giving tax concessions for unpaid bills. Therefore, you need to have a strong claim for eligibility.
To ensure your claim is approved, submit documents tracking your efforts to reach out to the customer. The submitted documents can include emails, faxes, and recorded virtual meetings (if available). Any contract highlighting the payment terms between you and your customer should also be shared to strengthen your claim.
Digitize customer communication so it’s easier to collect proof for bad debt deductions. Emails and recorded virtual meetings serve as better proof than offline communication, such as in-person meetings or phone calls.
Once you have the proof, fill out Schedule C (Form 1040 or 1040-SR) to report income loss from an unpaid invoice. You need to list details from the invoice as “ordinary loss” under Part V of Schedule C, Other Expenses.
If you've already paid taxes for an unpaid invoice in a fiscal year, you can file an amended return using Form 1040-X. If the deduction from the invoice has reduced your taxable income, the IRS will issue a refund.
Invest in an invoice management tool to record the details of all unpaid invoices. The software will help maintain accurate records and prevent mismatches or double entries.
While you may not be able to recover all your unpaid invoices, it’s important to know how to tackle such challenges should they arise. As discussed, you should meet certain criteria to be eligible to write off an unpaid invoice as a bad debt expense.
You can also use technology tools, such as invoice management software, to store invoices, receipts, credit memos, attachments, and other documents digitally. An invoice management tool can automate the payment collection process, allowing you to focus more on fostering customer relations. Here’s what else the software can do for your business:
Speeds up the collection process: An invoicing tool eliminates the need to process invoices manually. It lets you set alerts for upcoming invoice deadlines and send reminders to the finance team to contact customers for payments. Some tools also offer mobile apps to receive payments instantly.
Improves the chances of payment with progressive billing: Most invoicing tools facilitate progress billing, which lets you receive payments throughout the stages of a project rather than after project completion. You can set payment deadlines for each project stage and send notifications to customers to clear their dues. If you find a customer defaulting on payment, you can choose not to proceed with the remaining project phases.
Automates collections via the pull payment mechanism: Invoicing tools allow you to process payments directly from a customer’s bank account using a simple integration and pull payment mechanism. This process not only speeds up the collection process but also eliminates the need to chase customers for payments.
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