A small business can write off bad debt losses if it meets nominal requirements. To claim such a tax deduction, the following must be shown:

A. The existence of a legal relationship between the small business and debtor;

B. The receivables are worthless; and

C. The small business suffered an actual loss.

Proving there is a legal relationship between the small business and the debtor is pretty simple. You must show that the debtor has a legal obligation to pay. Most businesses issue invoices or sign contracts with debtors, and these documents suffice to prove the legal relationship. If you are not putting your business relationships in writing, you should begin doing so immediately.

Proving receivables are worthless is slightly more complex. A small business must show that the debt has become worthless and will remain so. You must also show that you took reasonable steps to collect the receivables, but you are not necessarily required to go to court to meet this requirement. A clear example of where you would meet this requirement is if the debtor filed for bankruptcy.

While proving that you suffered a loss may sound like the most straightforward requirement, the issue is a bit more complicated. The Tax Code defines the loss as an amount included in your books as income but never collected. A classic example of such a situation would be a manufacturer that provides products to retailers on credit. The manufacturer can show an actual loss if the retailer files for bankruptcy.

Unfortunately, there is almost no way to claim a loss if you provide hourly services and use a cash accounting method. The IRS does not consider the expenditure of time and effort to be a sustained economic loss.

Small businesses suffer all too often from uncollected receivables. If you failed to claim such losses as a tax deduction during your last three tax filing years, you should file amended tax returns to get a refund.