 Income tax 2022-2023. Business expenses, bad debts. Let's do some wealth preservation with some tax preparation. Most of this information comes from the Tax Guide for Small Business for Individuals Who Use Schedule C. Publication 334 Tax Year 2022. You can find it on the IRS website, irs.gov, irs.gov. Support Accounting Instruction by clicking the link below, giving you a free membership to all of the content on our website, broken out by category, further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. Looking at the income tax formula, we're focused on line one income. Remembering the first half of the income tax formula is in essence an income statement, although just an outline of scaffolding other forms, schedules flowing into these line items. One of those, the Schedule C, in essence an income statement in and of itself having business income minus business expenses. The net business income rolling into line one income here of the income tax formula. Here's the first page of the form 1040 noting the schedule C will in essence roll into the schedule one rolling in then finally to the first page of the form 1040 here. The schedule C is the profit or loss from business which is formatted in the structure of an income statement where we have income and expenses. We are now focused on the expenses side of the equation. So we're focused now on bad debts. So if someone owes you money, you cannot collect, you have a bad debt. So we're talking specifically about bad debt on the business side of things now. So typically that would be a scenario where possibly you did work for someone for example on account they owed you money and then at some future point, you've determined you're not going to get paid the money. And now you've got this bad debt type of situation. Now note, there could be some difference in how you're going to account for that if you're on an accrual basis versus a cashed basis. Because on an accrual basis, the basis you would most likely be using from an accounting standpoint, if you're doing work on account, then you would have recorded the revenue when you did the work. At some future point, then if you're not going to collect on it, then you didn't really have the revenue. It's another one of those items where you have a negated kind of revenue situation. So what should you do? Should you reduce the revenue in the current time period? That's not normally what we like to do because we like revenue only to continue going up. The other thing we can do is create like an expense account of bad debt, which is similar to what we saw with a returns and allowances situation where say inventory was returned. For example, where we made not an expense but a contra asset account still reducing net income in the same way. If it was a cash based system, then we would never have recorded the revenue in the first place because even though we did the work, we haven't actually received the revenue. So in that case, when they no longer pay us in the future, we wouldn't have recorded the revenue in the first place so we wouldn't have an expense necessary to negate the revenue. But most of the time, if you're dealing with a bad debt situation, you might have recorded revenue in the past and in the future when the bad debt becomes due, you might need an expense to compensate for the over reporting of revenue in the past. So there are two kinds of bad debts. You got business bad debt and non business bad debt. So business bad debt is generally one that comes from operating your trade or business. That's the one you would think you might be having something to do with the schedule C here. So you may be able to deduct business bad debts as an expense on your business tax return. So in other words, if you say, well, I loaned my cousin money just because just out of the kindness of my heart and lo and behold, my cousin who never pays anyone back didn't pay me back. Well, that's not really a business bad debt. You were just, you just gave your cousin money. Again, you should, you should stop doing that because the trend has been set at this point in time and you should, you know, recognize that. In any case, for non business bad debt, all other bad debts are non business bad debts are deductible as short term capital losses on form 8, 9, 4, 9 schedule D form 1040. So you can look there for more detail, but we're focused here on of course the business bad debt. If it was a business bad debt, you would think the debt arose from some type of business activity possibly through providing goods and services. So business bad debt, a business bad debt is a loss from the worthlessness of a debt that was either of the following. One, created or acquired in your business or two, closely related to your business when it became partly or totally worthless. So a debt is closely related to your business if your primary motive for incurring the debt is a business reason. So why did you take? Why did the debt happen? Business business reason happened. That's why the debt happened. So for example, you might have done work and so they owed you money and there and there as it is. So business bad debt, bad debts are mainly the result of credit sales to customers. A credit sale meaning not necessarily that you pay, they paid you with a credit card. And paying for credit card debt with worse credit card card, right? It means that you did work and instead of them paying you at the point in time you did the work, they're going to pay you in the future. It's an accounts payable kind of transaction. You did work on credit. You've got the bar tab going. You gave them a tab of credit in the future. You sent them, for example, an invoice. We did the work. Here's the invoice. We expect payment in 30 days or whatever. So they can also be the result of loans to suppliers, clients, employees or distributors. Goods and services. So now we've got a loan that's going to be a business kind of related to loan to suppliers, clients, employees, distributors. Goods and services that customers have not paid for are shown in your books as either accounts receivable or as notes receivable. So from an accounting standpoint, this would be an accrual thing. Because if you make sales on account, that means that you're not getting paid at the point you do the sale. So it's not like a restaurant situation. You're not getting paid at the point you do the sale. But rather you have to do the work first, like a law firm, accounting firm, you do the work, invoice the client. Then you have to track whether or not they're going to pay you, which means you usually track that in accounts receivable, which by its very nature is an accrual type of thing. And so if you're doing that, you're going to be on an accrual component. You've recorded the revenue when you did the work, but you hadn't yet received the money. And then of course the question is, what if they don't pay you the money in the future? Then you recorded revenue already and you got to account for the fact that you recorded revenue in the past, which might be an extents in the future. So if you are unable to collect any part of these accounts or notes receivable, the uncollectable part is a business bad debt caution. You can take a bad debt deduction for these accounts and notes receivable only if the amount you were owed was included in your gross income, either for the year the deduction is claimed or for a prior year. That's the point because in an accrual accounting system, you would have recorded the income. Like if you use QuickBooks or something, when you make an invoice billing a client or a customer for work done in the past, that's when it records revenue. The revenue is what you're being taxed on. Revenue is bad for taxes. So if in the future they don't pay you the accounts receivable, then you have overstated in essence your revenue in the past paying taxes on it. So that's when you would then be able to possibly get a bad debt expense to compensate for that in the current time period. If you didn't record revenue in the prior period because even though you're tracking accounts receivable, you're still doing a cash based system for some reason somehow, then you wouldn't get an expense to negate the revenue you recorded in the past because you didn't really record the expense because you didn't record the revenue until the point in time that you're going to receive the cash. Okay, so a cruel method. If you use an accrual method of accounting, you normally report income as you earn it. You can take a bad debt deduction for an uncollectible receivable if you have included the uncollectible amount in income. That's what we just talked about. Cash method, however, if you use the cash method of accounting, you normally report income when you receive it. You cannot take a bad debt deduction for amounts owed to you that you have not received and cannot collect if you never included those amounts in income. So again, that would be unusual in a business. Business is business. Where you invoice clients and have to track the accounts receivable, you would most likely be using an accrual method in that case. But if for whatever reason you were using a cash method, even though you're invoicing the client, you would never have recorded the revenue and therefore shouldn't have an expense to negate the revenue because you didn't record the revenue because you never got the cash in the first place. So more information. For more information about business bad debts, you can see chapter 10 of publication 535 if you want to dive into that in more detail. Notice that the reporting of accounts receivable can be a little bit complex if you just think about it in terms of like accounting methods to report accounts receivable. Small businesses oftentimes will simply be reporting the accounts receivable as they invoice clients and that's when they'll be reporting revenue. And then as the bad debts become due, then you may be able to write them off as bad debt expense when they happen in the future. That's called a direct write-off method from an accounting standpoint. You may also have heard of an allowance method just from an accounting standpoint and that's a system in which you all have a balance sheet. If you look at the balance sheet, for example, you've got accounts receivable on the balance sheet and you know that some of those accounts receivables aren't going to be collectible. You don't know which ones aren't, but you can estimate based on prior history that some of them are going to be bad debt expenses. So you might then think that you should, to properly report your books, come up with some kind of estimate to determine how much of the accounts receivable are uncollectible and how much of the sales that were made in the current time frame aren't really sales because you're not going to be able to collect on them and try to record the estimate for the uncollectible portion. And then if you do that method, then you've got an issue that you've got to say, okay, is there a difference between what I have to do for taxes versus financial reporting? That might be a generally accepted accounting principle thing to do if you are a publicly traded company, for example. And then you've got to think about what you have to do for taxes in that event as well. But for most small businesses, they enter things for accounts receivable. If they use QuickBooks, for example, when they invoice someone, you record accounts receivable and income is recorded at that point in time. If they're never going to get paid, if you determine that a receivable is not going to be paid, then the thing to do is typically to write it off to bad debt and that's a direct write-off type of method. So non-business bad debt. All other bad debts or non-business bad debts are deductible as short-term capital losses on Form 8, 9, 4, 9 Schedule D. So if you had a bad debt other than that's not business related to it, then you can take a look at the rules for the Schedule D. So for more information on non-business bad debt, you can see publication 550.