Question

Tracy billed Pat $8,000 for services she performed. Pat has never paid the bill, his business no longer exists, and his whereabouts are unknown.

What is the treatment of an accrual basis taxpayer?
What is the treatment of a cash basis taxpayer?

Answer 1

For an accrual basis taxpayer, the $8,000 billed can be written off as a bad debt expense if deemed uncollectible, potentially reducing taxable income. For a cash-based taxpayer, no bad debt deduction is taken because the income was never recorded. The uncollectible amount should be removed from the books in both cases to accurately represent the financial situation.

Step-by-step explanation:

The treatment of bad debts like the one Tracy is facing with Pat depends on the accounting method used by the taxpayer. If Tracy is an accrual basis taxpayer, she would have recorded the $8,000 as income when she earned it, regardless of whether Pat had paid or not. In this scenario, if Tracy determines that the amount is uncollectible, she may be able to write it off as a bad debt expense on her tax return, thus reducing her taxable income.

On the other hand, if Tracy is a cash-based taxpayer, she records income only when it is actually received. Since Tracy never received the $8,000 from Pat, she would not have reported the $8,000 as income. Consequently, if Pat's payment is never received, Tracy would not take a bad debt deduction because the income was never reported in the first place.

In both cases, if the bad debt is deemed completely uncollectible, Tracy should remove the receivable from her books to reflect the true economic reality of her financial situation.