Business owners often ask if they can write off amounts owed by customers on unpaid invoices as deductions. The answer depends on whether the taxpayer is using the cash basis or the accrual basis of accounting. For cash-basis taxpayers, however, the short answer is no. You generally can’t take a deduction for unpaid amounts because your taxable income already shows only the cash you actually received.
Cash Basis vs. Accrual Basis Accounting
- Accrual Basis: Income is reported in the year it’s earned, whether or not payment has been received; and expenses are deducted when they are incurred, not necessarily when they are paid. For accrual-basis taxpayers, unpaid customer invoices increase taxable income because the revenue is reported even if the payment has not been collected. If the invoice is later determined to be uncollectible, the business may write off the bad debt as an expense.
- Cash Basis: Income is reported only when it’s actually received, and expenses are deducted when they are paid. This means that an unpaid invoice has no impact on taxable income for cash-basis taxpayers because it was never reported as income to begin with.
Why Cash-Basis Taxpayers Don’t Deduct Unpaid Invoices
When a cash basis taxpayer has an unpaid invoice, there is no need for a separate deduction since the income was never recognized. This accounting method for taxable income already reflects the fact that the customer didn’t pay.
Example:
Imagine you invoice a customer for $10,000 but they only pay $7,000. Under the cash basis:
- You report only the $7,000 you received as income.
- The unpaid $3,000 is never included in your taxable income.
If you were allowed to take an additional $3,000 deduction for the unpaid invoice, this would essentially double count the reduction, as the $3,000 was already excluded from income in the first place.
In contrast, an accrual-basis taxpayer would have reported the entire $10,000 as income when the invoice was issued, and the $3,000 unpaid portion could be deducted later as a bad debt.
Tax Return Preparation for Cash-Basis Taxpayers
One advantage of the cash basis is simplicity. When preparing your tax return, your accountant only needs to know how much cash your business actually collected from customers during the year. Whether or not customers paid everything they were supposed to doesn’t affect your taxable income calculation.
For example:
- If you billed $100,000 in total invoices for the year but only collected $90,000 in payments, your taxable income is based on the $90,000 you received.
- The unpaid $10,000 is irrelevant for tax purposes because it was never included in income.
By reporting only the amount collected, cash-basis taxpayers inherently avoid overstating income, making additional write-offs for unpaid invoices unnecessary.
What About Business Expenses Related to Unpaid Invoices?
If you incurred expenses in providing goods or services to a customer who didn’t pay, those expenses are still deductible under the cash basis as long as you actually paid them. The deductibility of your business expenses isn’t tied to whether or not you collect revenue from the related invoices.
For instance, if you spent $2,000 on materials to fulfill a $10,000 invoice but the customer only paid $7,000, you would still deduct the $2,000 expense (assuming it was paid during the tax year).
Key Takeaways for Cash-Basis Taxpayers:
- No double-counting: You cannot deduct unpaid invoices as a bad debt because they were never included in your taxable income in the first place.
- Simplicity of reporting: Taxable income under the cash basis is based only on cash received, regardless of billing or collections issues.
- Expense deductions are unaffected: Business expenses related to unpaid invoices are still deductible if they were actually paid.
For cash-basis taxpayers, understanding this concept helps avoid confusion and ensures compliance with IRS rules. If you are unsure whether your accounting method is a cash basis or an accrual basis; or if you have questions about how to properly report income and deductions, consult your accountant or tax advisor to clarify.