SMALL BUSINESS RESOURCES

The best way to write off bad debt

4 min read

Throughout your business life you’ll likely have trouble with unpaid invoices and bad debts. In certain circumstances you’ll need to have these bad debts written off for tax purposes. So, when can you write off a bad debt?

Typically, a larger business gets their payments team to send a demand letter for unpaid invoices and then receives the payment. For small businesses unpaid invoices, the owner may simply send a few emails or make a few phone calls until the payment is made.

But what happens when your client’s financial position makes it doubtful that they’ll pay the debt they owe to you? Or what if you have the misfortune of dealing with a customer that takes every possible action to evade their payment obligations? You may have to write off unpaid invoices.

This is bad debt; one that you’re unlikely to have repaid. What happens next? You may have to write off unpaid invoices, as it may provide your business with a tax deductible expense.

But when and how can you do this?

Unpaid invoices

No matter what industry you work in, if you’re self-employed or the head of a company, chances are you’ll have experienced trouble with unpaid invoices. This is also referred to as accounts receivable (money you’re owed for services provided).

The problem is by no means limited to Australia. A survey conducted by the Commercial Collection Agency Association in the USA found that – as time goes by – the likelihood of receiving payment in full greatly diminishes.

The findings showed that while most invoices are paid in full before the due date:

  • The likelihood that they’ll be paid at all has already dropped by over 5% by time that due date rolls around.
  • Thirty days later, this has dropped even further to only 89.9%.
  • Ninety days after the due date, only 69.6% of invoices get paid.
  • Two years after the due date, the likelihood of receiving payment for an outstanding invoice drops to only 9.3%.

This creates an accounts receivable blackhole, and it’s the cause of major cash flow problems for businesses.

When can you write off a bad debt?

When exactly can you write off a bad debt? Let’s say you have a possible bad debt on your account receivable books. In order to classify the amount owing to you as a bad debt for tax purposes, the Australian Taxation Office says it must be 12 months overdue.

Once the debt slips beyond this 12-month mark, the ATO will recognise the unlikelihood that it will be paid and will allow you to write it off.

Demand letter for unpaid invoices

An important tool in your kit when assessing bad debts or potential bad debts is the ‘letter of demand’.

A letter of demand essentially communicates how much the business in question is in debt to you, what the debt is for and when they need to settle the invoice by. It also usually includes a warning of impending legal action if the invoice is not settled.

The demand letter for unpaid invoices is the final step in your attempt to receive payment for services.

Make sure you’ve placed phone calls and sent out ‘late payment notifications’ with your invoice attached before writing such a letter.

The letter of demand also provides a paper trail proving your claim of a bad debt to the ATO and should be filed safely as a record.

If you need help with writing a letter of demand, the ATO has provided information and a template here.

Writing off a bad debt

How do you go about writing off those unpaid invoices against your tax obligations?

Well, first you need to wait for 12 months to pass as stipulated above, only then will the ATO allow it to be a legitimate bad debt.

Maybe you know that you aren’t going to be paid by a client, and they have made it clear that they know that too.

It’s important to note that this income must have already been recorded as part of your assessable income either for that year’s tax assessment return or for any previous year. If this is the case, you may submit the updated information regarding the non-payment to the taxation office as part of your assessable income tax return.

Things to remember about writing off bad debts

The Income Tax Assessment Act 1997, section 25-35 stipulates the following;

“You can deduct a debt (or part of a debt) that you write off as bad in the income year if:
(a) it was included in your assessable income for the income year or for an earlier income, or;
(b) it is in respect of money that you lent in the ordinary course of your business of lending money.”

Always bear this in mind when you’re trying to write off any bad debts or unpaid invoices. We’ve compiled some tips to help you through the process:

  • Remember to complete the process of writing off the unpaid invoice before the end of the financial year. This one might seem obvious, but it can be easily forgotten considering all your accounting and tax obligations.
  • You can only write off a debt which is bad to ensure a deduction is allowable, i.e., it needs to be a debt which is unlikely to be paid at all.
  • All debts which are written off must be supported by documented paperwork.
  • Any amounts that you write off are deducted from your bottom-line profits, so be cautious about the process of writing off bad debts.
  • If you report your income on an accrual basis, you may be eligible to claim a refund of the GST paid to the ATO on sales. Income from business activities will generally be returned on an accruals basis and will ordinarily be derived for tax purposes when a recoverable debt arises (i.e. when the invoice is raised).
  • When an amount has been outstanding beyond 12 months, you can write it off and claim GST credits

Make sure you try all options for collecting your accounts receivable balance before deciding to write off a bad debt, as this will impact your profit. Importantly, bad debts must be written off during the year and not after the end of the financial year.

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Reckon does not provide tax or legal advice. Information in this blog should not be relied upon as professional advice. For your individual circumstances you should consult with your own professional adviser, tax expert, or lawyer.

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