Bad Debt from Bankrupt Fish Buyer
Occasionally, a fish buyer will go bankrupt without paying for the fish. The accounting method used for your business will determine where you report the loss on your tax return. Most individuals and many small businesses with no inventory use the cash method of accounting. However, if an inventory is necessary to account for your income, you must use an accrual method of accounting for at least sales and purchases.
The loss you have experienced is considered a business bad debt. Whether or not you can deduct the bad debt depends upon your accounting method and whether you have previously included the fish sales in your business income. For credit sales, in order to claim a bad debt deduction, you must have previously included the credit sales in your business income.
Under the cash method, you include all items of income actually or constructively received during the year in gross income for that year, and you must generally deduct expenses in the tax year in which you actually pay them. However, an expense paid in advance can be deducted only in the year to which it applies. Since you did not receive the fish sale income, if you are using the cash method of accounting you would not have previously included this in your business income. As a result, when the income isn't received, there is no deductible business bad debt. You still have experienced a loss and have a bad debt; it just isn't a type of bad debt that can be deducted on your tax return.
Under the accrual method of accounting, income is generally reported in the year earned and expenses are deducted or capitalized in the year incurred. The purpose of this method of accounting is to match income and expenses in the correct year. An accrual method taxpayer would normally have included the fish sales in their business income in the year it was earned (i.e., the year the fish were sold). Assuming that you were on the accrual method and assuming you actually did include these fish sales in your income in the year of the sale, then a business bad debt is allowed in the year the debt becomes worthless.
If a bad debt is allowable, it is claimed on the appropriate line on the return. For Schedule C (Form 1040) taxpayers, it is deducted on Line 48; Form 1065 (partnership) filers, on line 12; Form 1120 (corporation) filers, on line 15; and Form 1120S (Subchapter S corporation) filers, on line 10.