 Income tax 2021-2022, business expenses, bad debts. Get ready to get refunds to the max, diving into income tax 2021-2022. Most of this information can be found in Publication 334, Tax Guide for Small Business 2021, looking at the income tax formula line 1, income. There would be a sub-schedule having in essence an income statement, income and expenses. We're focused on the expenses side of things. This time, the expenses basically be in deductions. The net then of that schedule flowing into line 1, income of the income tax formula, as well as page 1 of the form 1040, the tax return where we would have the schedule C, bottom line rolling into the schedule 1, schedule 1 rolling in to page 1 of the 1040 line number 8. We see here, here's the schedule C, basically an income statement, income and expenses. We're focused on the expenses here, remembering that in the real world, expenses are bad usually, and the income is good, but for tax world, it's flipped on its head, it's upside down, the expenses can be called deductions. So we're trying to maximize the expense side of things looking here at the bad debts. Bad debt, bad debt. I don't know what good debt is, but we're talking bad debt right here. So if someone owes you money, you cannot collect, you have a bad debt. There are two kinds of bad debt, business bad debts and non-business bad debts. So we're looking at the schedule C here and the deductibility for it. So we're talking about basically business bad debt for the most part. So in other words, if you gave someone just like a loan, a personal loan or something like that to your friends, your family or whatnot, and they didn't pay you back or something like that, then we're not talking about that in regards to your business typically. With the business, you're typically talking about a type of debt where you did work and you charged the client, possibly invoicing the client, and then you don't think that you're ever going to collect from that client. The client has fallen from the face of the earth. You can't get ahold of them, and that's the kind of bad debt we're talking about. Now with the bad debt, it's a little tricky depending on the kind of accounting system that you're using. Are you using a cash basis system? And a cruel basis system. Now normally when we think about bad debts, we're using an accrual based system because we're talking about someone that owed us money for work that we did typically, and therefore we're tracking the receivable and if we're tracking the receivable, we're doing an accrual thing usually because we recorded the invoice or the income when we build the client or invoice the client. So in other words, if we were on a cash basis method, we wouldn't really have accounts receivable because we wouldn't be invoicing the client. We're usually on a cash basis method if we do work at the same point in time that we build the client or we do the work at the same point in time that we get paid from the client, like a restaurant. If we're in a type of business where we do the work first and then send the bill to the client, then usually we record the income when we enter the bill or the invoice into the system. For example, when you enter the invoice, that's when the software will usually record the income, then we'll track the accounts receivable to see if they then pay us. So in that instance, if they're not going to pay us, that would mean that we recorded income in the past which we shouldn't have recorded or which is now invalid, and that means we might have paid taxes on it in the past and therefore we should get a benefit from it if the collection is not going to be able to be taking place and that would be the bad debt expense which is basically like a reversal of the income but we're not going to put it on the income line, we're going to put it in an expense line. That's the general idea. So a business bad debt is generally one that comes from operating your trade or business. You may be able to deduct business bad debts as an expense on your business tax return. A business bad debt is a loss from the worthlessness of a debt that was either of the following. Number one, created or acquired in your business. Number two, closely related to your business when it became partly or totally worthless. A debt is closely related to your business if your primary motive for incurring the debt is a business reason. So obviously if you had a debt that was incurred that was business related, meaning like you build someone for example, then that would be clearly a business related debt that if it didn't become cleared or didn't happen then might qualify you for the bad debt. Business bad debts are mainly the result of credit sales to customers. That's the typical kind of system. You invoice the customer, you didn't get paid for it. They can also be the result of loans to suppliers, clients, employees or distributors, goods and services. So that means normally they would be like the accounts receivable, but you could have other kind of loans that you had for example to employees or something like that that become bad. So goods and services that customers have not paid for are shown in your books as either accounts receivable or notes receivable. So if you use like a QuickBooks or whatever accounting system let's just envision QuickBooks when you invoice the customer you increase the accounts receivable, the other side recorded revenue. You recorded the revenue then when you enter the invoice that's what an accrual system does. And so if they don't pay you on the invoice that is the problem because we already recorded the income which is bad for taxes because we had to pay taxes on it so now we should get a benefit of the deduction of bad debt. So if you are unable to collect any part of these accounts or notes receivable the uncollectable part is business bad debt. You can take a bad debt deduction for these accounts and for these accounts and notes receivable only if the amount you were owed was included in gross income either for the year deduction is claimed or a prior year. So the point of the bad debt being deductible is that if you had to pay taxes on it then you're going to get the deduction. If you had to incur the bad thing for taxes which is income because then you're going to pay a portion of that to the government then you should get the good side which is going to be the expense related to the bad debt. Now you might think why is it called bad debt like why don't we just make it a contra income account because it's really negating an income item that happened and one reason you might do it that way is because usually we only like income accounts to go up we don't really like to go back and negate the income and the income might have happened like in a prior year so it might not have matching up in the same time frame it might be on the prior year tax return so we could have two different line items by having the bad debt expense as a different line item rather than a contra income account. So a cruel method, if you use an accrual method not like a mean method, we're not being cruel it's an accounting method as opposed to the cash method so 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 so typically again if you have bad debt you would think that you are using an accrual method but you might be on a cash method and if you use the cash method of accounting you normally report income when you receive payment you cannot take a bad debt deduction for amounts you owed to you that you have not received and cannot collect in your if you never included those amounts in income so if you're billing someone and they didn't pay you if you did work for example and they didn't pay you the money then if you're on a cash basis method then you would never have recorded when you invoice them for example you would never have recorded the income at that point in time now again if you're in the kind of business where you have to do work and then invoice the client and they pay you later and you use like accounting software for example it's going to record it on an accrual basis so you'll probably be on an accrual method in that case but you might have a method where you're tracking the information on a sub-schedule or something like that and you're not recording the accounts receivable or whatever and you're waiting until you actually receive the cash before you record it in income in that instance you would never have recorded it in income so you never had the bad thing happen in the first place of income that you had to pay taxes on so you also don't get the deduction related to it so this bad debt expense and accounts receivable are really accrual type of things that happen not cash basings so more information for more information about business bad debt you can see chapter 10 you can take a look at publication 535 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 so if you have other bad debts that you want to look into we're looking at the form 8, 9, 4, 9 and schedule D which you can find the instructions for and so for more information on non-business bad debt you can also take a look at publication 550 on the IRS website IRS.gov IRS.gov