When it comes to running a business, having outstanding invoices that turn into uncollectible receivables or simply bad debt is a fact of life. The Internal Revenue Service (IRS) has a safe harbor that permits businesses to reduce consideration of such bad debt from taxation, if it qualifies. However, understanding how to determine if a business is eligible is essential to making the most of it when a business files its taxes.
Defining the Nonaccrual Experience Method (NAE)
When businesses perform a service, they expect to be paid. However, they sometimes have unpaid invoices that are uncollectible. One provision within the IRS’ Internal Revenue Code (IRC) is that of the nonaccrual experience method (NAE) and how it intersects with bad debts.
How It Works
Once a company sees bad debt in its system after customers fail to pay their invoices, it calculates the amounts it projects it won’t be able to collect. Projecting bad debt is accomplished by the company looking at previous experiences with its payees. It’s important to note that this accounting is used by businesses for only a portion of their projected uncollectable customer bad debt; businesses similarly project the remaining percentage they expect to collect from outstanding invoices in the future.
One important step for businesses to determine their eligibility for relief from the accrual segment of uncollectible revenue, per the U.S. Security & Exchange Commission (SEC), is by determining their industry classification. Sample industries include legal professionals, engineers, performance art professionals, architects, and actuaries.
It’s important to note that if businesses don’t use this method, they may charge off such debts. Charge-offs are when a company writes the debt off its balance sheet and expenses the uncollectible funds on the income statement. Companies must also adhere to the following criteria to take advantage of the safe harbor:
- The company must currently use the accrual method of accounting when recording revenues, and not the cash method to account for revenue.
- The company, in a single year, within the past 36 months, has earned up to, but no more than $5 million in gross receipts.
IRS Guidance
Beginning in September 2011, the Internal Revenue Service permitted taxpayers to use the NAE method to determine applicability by applying a factor of 95 percent to their allowance for bad debts via their past 60 months of financial documents. This permits businesses to exclude qualifying uncollectible revenues from their taxable income, which is beneficial for lowering the amount of taxes owed. It is often easier for NAE-specific designated industries to qualify; however, only companies with the appropriate amount of historical information to substantiate are eligible.
Further Considerations and Conclusion
One example of this safe harbor includes having financial information that’s expertly tracked for the past 60 months via financial statements. If the company can’t substantiate it, they won’t be able to qualify. Similarly, eligible services provided or the resulting receivables that have interest and/or financial penalties attached, are ineligible.
When it comes to navigating the IRS code, the NAE can provide another way for eligible companies to maximize filings and tax obligations.
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