Some service providers can accelerate recognition of bad debt
TAX BLOG |
To recognize a bad debt, an accrual method taxpayer is generally required to be on a specific charge-off method (i.e., a deduction is allowed for income tax purposes when the bad debt has been explicitly written off for GAAP purposes). However, certain service providers may be able to accelerate the recognition of bad debt to a time prior to the debt is specifically charged-off.
Accrual method taxpayers performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting can change their method of accounting for bad debts to the nonaccrual-experience (NAE) method. Under this method, the taxpayer determines the uncollectible amount of each eligible receivable and recognizes into gross income the total amount, less the estimated bad debts, determined under the taxpayer’s NAE method.
While the final regulations for the nonaccrual experience method were published in 2006 and the book method safe harbor (discussed below) was published in 2011, many otherwise qualifying taxpayers may not be aware of the method or may be under the impression that the computation of the nonaccrual amount is not worth the effort. It may be worthwhile for qualifying taxpayers to revisit the NAE method of accounting to see if it provides a benefit over the specific charge-off method.
The IRS provides six safe-harbors to compute the amount of uncollectible receivables. One of these, the NAE book safe harbor is generally the most expedient method of accounting for taxpayers to adopt or change their method of accounting for bad debts to the NAE method. Under this method, a taxpayer may compute its uncollectible amount under NAE book safe harbor method by multiplying the portion of year-end allowance for doubtful accounts on the taxpayer’s applicable financial statement that is attributable to current year NAE-eligible accounts receivable by 95 percent.
To use the book safe harbor method, a taxpayer must have an applicable financial statement, defined as:
1) A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders);
2) A certified audited financial statement that is accompanied by the report of an independent CPA (or in the case of a foreign corporation, by the report of a similarly qualified independent professional), that is used for —
a) Credit purposes,
b) Reporting to shareholders, or
c) Any other substantial non-tax purpose, or
3) A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the Internal Revenue Service).
There are also specific requirements on the type of accounts receivable for which the nonaccrual-experience method may be used. These requirements provide that the method cannot be used for accounts receivable for amounts not provided through the performance of services (i.e., supplies) or for accounts receivable where a taxpayer charges interest or penalties for failure to timely pay.