Contrary to what many freelancers, consultants and other self-employed individuals mistakenly believe, long-standing regulations usually prohibit most of them from claiming bad-debt deductions on their federal and state returns when they are unable to recover amounts due from clients and customers. Why should freelancers forget about any kind of relief when they fill out their tax forms? Because, says the Internal Revenue Service, there are no tax breaks for "cash-basis taxpayers," agency argot for individuals who weren't previously required to count those unpaid amounts as reportable income. The Internal Revenue Code helps ease the hurt only for freelancers who come within the definition of "accrual basis taxpayers," meaning individuals who were previously required to declare such amounts as income. Below is a representative question that I have frequently received from freelancers.
Question: Last year, a magazine agreed to pay $2,000 for an article, plus reimburse my
expenses. Usually, I ask and receive more for this kind of article, but I wanted the exposure this publication could provide. This year, I made sure to deliver the article well in advance of its due date, along with my bill for $2,700, comprised of the $2,000 fee and $700 for travel, telephone and other expenses incurred in the course of research. The assignment turned out to be a fiasco. I will collect zilch, because the magazine went kaput; last I heard of its publishers, they had gone into the witness protection program.
When tax time rolls around, I know where the various out-of-pocket expenses aggregating $700 go on which lines of Form 1040's Schedule C (Profit or Loss From Business). It seems only fair that I should be entitled to a further reduction in my income taxes with a bad-debt deduction on Schedule C for that unpaid $2,000 fee. As I fall into a 30 percent federal and state bracket, the additional write-off works out to a savings of $600--not monumental moola, but likely enough to cover several sumptuous spreads of my favorite paella at a Zagat-recommended restaurant. Some extra consolation is that a decrease in Schedule C's net profit will lower what I owe for self-employment taxes. But where do I enter the $2,000 deduction in the expenses part of Schedule C? Or am I supposed to amend the previous year's return in order to claim it?
Answer: Downsize your dining desires and be content to gorge with the other gringos at La Casa Internacional de Pancakes. You can't take any deduction for the $2,000. The snag: You're what's known as a "cash-basis taxpayer." That's the IRS's designation of individuals (including most of us) who generally don't have to report payments for articles, books and other income items until the year that they actually receive them and don't get to deduct their expenses until the year that they pay them. As the tax code doesn't require you to count the $2,000 as reportable income, it doesn't allow you to deduct an equivalent amount. Only if you were an "accrual basis taxpayer," and had previously counted the $2,000 as reportable income at the time it became due to you, could you deduct it now, as it hasn't actually arrived and is a lost cause.
Julian Block is an attorney and author based in Larchmont, N.Y. He has been cited as: "a leading tax professional" (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine). Information about his books is at julianblocktaxexpert.com.