Why do I owe taxes on uncollected revenue?

As a small business owner in Canada, it can be frustrating to find yourself owing taxes on money you haven't actually received yet. This common situation often leaves business owners wondering: "How can I owe taxes on revenue I haven't collected?" Let's break this down and understand why this happens.

The Difference Between Cash and Accrual Accounting

The main reason for this situation lies in the accounting method your business uses. There are two primary methods:

• Cash Basis Accounting: Revenue is recorded when you receive payment
• Accrual Basis Accounting: Revenue is recorded when you earn it (i.e., when you invoice your customer)

Most Canadian businesses are required to use accrual accounting for tax purposes, especially if they earn more than $5 million in revenue or are incorporated.

Why Accrual Accounting Matters for Taxes

Under accrual accounting, you must report income in the fiscal period you earn it, regardless of when you receive payment. For example:

• If you invoice a client for $10,000 in December 2024
• But they don't pay until January 2025
• You must still report that $10,000 as income for 2024

In Canada, this has two effects:

1. You will owe business tax. Whether you’re a sole proprietor or corporation
2. You will owe sales tax based on your provincial sales tax rate

Managing Your Cash Flow With Accrual Accounting

To avoid cash flow problems consider the below strategies.

1. Set aside a percentage of invoiced amounts for future tax payments

A simple way to manage this is to pick a percentage (hint: maybe your provinces sales tax rate) and put this aside into another account.

You can either do this for every invoice you create, or at the end of each month

• See how much revenue you generated
• Multiply that by the sales tax rate of your province
• And move that amount from your operating to your savings account

If you work with an accountant or bookkeeper (like us at Blueprint) then we can quickly tell you how much money you should set aside each month using actual figures from your accounting.

2. Maintain a separate tax savings account

This ties into the above strategy, but always keep a separate savings account for any tax liabilities.

You can create one or two accounts

1. For sales tax AND business tax
2. Separate accounts for sales tax and business tax

We always recommend this strategy to our clients when they sign on with us because it makes sure they aren’t spending money that isn’t yours.

Yes, that’s right. The sales tax you charge to clients is owed to the government.

Don’t make a silly mistake and spend that money. Put it aside.

3. Consider requesting deposits or shorter payment terms from clients

You added the payment due date on your invoice, right?

You should always have the payment due date on your invoice. Otherwise, how will your clients know when to pay you?

Short answer: they won’t. And they will (maybe purposely) continue to defer your payment until you bother them enough.

So, you can instead request a deposit or shorten your payment terms.

OR…

4. Get paid up front for all work that you perform

This is the preferred option.

Many service-based businesses get paid up-front in one form or another.

This could be a partial deposit. Or a full payment up-front.

At Blueprint, we take payment on the first of the month for the month ahead for recurring work. No ifs, ands, or buts about it.

When there is project work to complete, we will mostly take a deposit and true that up at the end of the project if that’s needed.

Doing this helps manage cash flow so that we can, for example, pay our team and other suppliers.

5. Track accounts receivable closely and follow up on overdue payments

You should be monitoring your accounts receivable monthly at a minimum. Weekly or even daily is preferable.

The longer invoices sit overdue the less likely you are to collect on them.

So make sure you’re keeping on eye on your overdue invoices and follow up with customers promptly to receive payment if you don’t follow strategy 3 or 4.

6. Send overdue invoices to collections

This is a last ditch effort if you don’t follow strategy 3 or 4 when it comes to getting paid.

Sending a customer to collections isn’t fun, but it can result in a better outcome: some cash in your account vs none.

When you send a customer to collections it can negatively impact their credit ratings and business.

And no sane business owner wants that to happen to their business.

Keep in mind that when you send a customer to collections this means you won’t get 100% of your invoice value back.

Every collection agency takes a percentage of the total invoice value, and it can vary based on several factors:

1. Age of the invoice
2. Value of the invoice, and even
3. Information available to contact the customer

The Silver Lining: Bad Debt Deductions

If you've paid taxes on income that later becomes uncollectible, you can claim a bad debt deduction in the year the debt becomes uncollectible. This allows you to recover the taxes paid on income you never received.

For example:

• If you invoice a client for $10,000 in December 2024
• But they’re unwilling to pay for one reason or another
• You must still report that $10,000 as income for 2024
• However, in a future period you could claim a bad debt deduction that creates an expense in a future period and reduces your taxes owing

When this happens you’re effectively reclaiming the taxes paid on prior income.

Key Takeaways

While owing taxes on uncollected revenue may seem counterintuitive, it's a standard part of accrual accounting. The key is to:

• Understand your accounting method and its tax implications
• Plan ahead for tax payments
• Maintain strong cash flow management practices
• Keep detailed records of your accounts receivable

Remember, consulting with a qualified accountant (hint: that’s us at Blueprint) can help you better understand your specific situation and develop strategies to manage your tax obligations effectively.

‍