How should design agency owners handle bad debts?

The Inevitable Challenge of Unpaid Invoices

For design agency owners, chasing creativity and client satisfaction is the goal, but chasing payments can be a draining reality. A client goes into administration, a project relationship sours, or an invoice simply slips through the cracks—bad debts are an operational headache that can also create a significant tax problem if not managed correctly. However, with the right approach, you can mitigate the financial impact. Understanding how to handle bad debts is not just about writing off a loss; it's about unlocking potential tax relief and ensuring your accounts accurately reflect your business's health. This process is a critical component of strategic financial management for any UK creative business.

The core question for many is: how should design agency owners handle bad debts from both an accounting and a tax perspective? The answer involves a two-pronged strategy: firstly, formally writing off the debt in your accounts, and secondly, claiming the appropriate tax relief from HMRC, either through corporation tax or VAT adjustments. Getting this right ensures you are not paying tax on income you have never actually received. This is where meticulous record-keeping and a clear understanding of HMRC's rules become non-negotiable. Modern tax planning software can be instrumental in tracking aged debts, calculating relief, and maintaining the necessary audit trail for compliance.

Formally Writing Off the Debt: The First Essential Step

Before any tax relief can be considered, you must take the formal step of writing off the debt in your company's accounting records. This isn't just a mental note; it requires an official entry. You should create a journal entry that debits a "Bad Debt Expense" account (or similar) and credits the relevant "Accounts Receivable" or "Trade Debtors" account. This action removes the unpaid invoice from your assets and recognises the expense in your profit and loss account.

It's crucial to document the reason for the write-off. HMRC may request evidence that you have taken reasonable steps to recover the debt. This evidence can include:

• Copies of final reminder letters and emails.
• Records of phone calls or meetings discussing the overdue payment.
• Proof that the client has entered liquidation or administration.
• Notes on any insolvency practitioner communications.

This documentation proves the debt is genuinely irrecoverable, not just late. For a design agency, this step is vital to ensure your balance sheet presents a true and fair view, which is especially important if you are seeking investment or loans.

Claiming Corporation Tax Relief on Bad Debts

Once the debt is written off in your accounts, you can claim corporation tax relief. The relief works by reducing your taxable profits. Since you declared the invoice as income when you raised it (likely under the accruals basis), you paid corporation tax on that presumed profit. When the money never arrives, you are entitled to claim that tax back.

The mechanics are straightforward: the amount you write off is treated as an allowable business expense. It directly reduces your pre-tax profit figure on your corporation tax return (CT600). For the 2024/25 financial year, with the main corporation tax rate at 25% for profits over £250,000, and 19% for profits under £50,000 (with marginal relief in between), the relief can be meaningful.

Example: Your design agency writes off a £10,000 bad debt. If your company pays tax at the 19% small profits rate, this bad debt expense reduces your corporation tax bill by £1,900 (£10,000 x 19%). Using a dedicated tax calculator within a tax planning platform allows you to model this impact instantly, showing you the exact cash flow benefit of the relief and helping you optimize your tax position accurately.

Remember, the debt must be written off in the accounting period in which you claim the relief. You cannot anticipate future bad debts, but you can create a general provision for doubtful debts based on past experience, which is also tax-deductible.

VAT Treatment: The Cash Accounting vs. Standard Accounting Choice

VAT on bad debts has its own specific rules, and the treatment depends on which VAT accounting scheme you use.

If you use the Standard VAT Accounting Scheme: You accounted for output VAT on the invoice when you issued it, even though you hadn't been paid. If the debt later turns bad, you can reclaim that VAT from HMRC. To do this, the debt must be at least 6 months old (from the later of the payment due date or the date of supply), and you must have written it off in your accounts. You reclaim the VAT by adjusting your VAT return (Box 4) and keeping a separate "VAT Bad Debt Relief" record.

If you use the VAT Cash Accounting Scheme: The process is simpler. Under this scheme, you only account for VAT on invoices when you are actually paid. Therefore, if you are never paid, you never declare the VAT in the first place. This scheme can be a proactive tax planning strategy for design agencies with a high volume of smaller clients or longer payment terms, as it automatically protects your cash flow from bad debt VAT liabilities.

Deciding which scheme is best is a key part of tax scenario planning. A robust tax planning platform can help you model the cash flow implications of each scheme based on your typical invoice size and debtor history.

Practical Steps and Proactive Measures for Design Agencies

Knowing how to handle bad debts is reactive. The smarter strategy is to minimise their occurrence. Implement clear payment terms (e.g., 30 days net), issue invoices promptly, and use a systematic process for chasing overdue payments. Consider taking deposits for large projects, especially with new clients.

From a tax administration perspective, integrate bad debt tracking into your regular financial review. When you identify a debt as irrecoverable:

1. Formally approve the write-off (director's minute or manager's authorisation).
2. Make the accounting journal entry.
3. If on Standard VAT, prepare the VAT bad debt relief claim.
4. File the claim in your next VAT return (for VAT) and ensure the expense is included in your management accounts for the corporation tax computation.
5. Securely store all supporting evidence for at least 6 years from the end of the accounting period.

This is where technology transforms a cumbersome process. Modern tax planning software automates reminders, flags aged debts, and can even help generate the necessary documentation and calculations for both VAT and corporation tax relief, ensuring HMRC compliance is maintained with minimal manual effort.

Turning a Setback into a Strategically Managed Event

So, how should design agency owners handle bad debts? The answer is systematically and strategically. By formally writing off the debt, claiming the due corporation tax relief, and correctly adjusting for VAT, you transform a business loss into a partial financial recovery. More importantly, embedding these processes into your financial management protects your cash flow and ensures your reported profits are accurate.

While the creative work is your focus, the financial framework that supports it must be robust. Leveraging technology to handle the complexity of tax relief on bad debts frees you up to concentrate on client projects and business growth. Exploring how a dedicated tax planning software solution can automate these critical compliance tasks is a smart investment for any design agency owner looking to build a resilient and financially savvy business. To see how this works in practice, you can explore the tools available that are built for modern UK businesses.