As a business owner, you’re likely familiar with the potential for financial setbacks, whether navigating the initial expenses of a startup or adapting to shifts in the economy or industry as an established company. Fortunately, the IRS offers businesses a deduction (up to $626,000 for married filers) when they experience a net operating loss. Read this article to understand how to calculate and leverage your net operating loss to reduce your tax liability.
Are business losses tax deductible?
Yes, business losses are generally tax-deductible. When a business’s expenses exceed its revenues, resulting in a net operating loss (NOL), you can often use this loss to offset other income and reduce the overall tax liability of the business.
However, how you report and deduct a business loss depends on your business structure.
- Sole proprietors report business income and expenses on Schedule C (Form 1040).
- Partnerships and multi-member LLCs (taxed as partnerships) file an information return using Schedule K (Form 1065).
- S corporations file Form 1120-S and pass income and losses through to shareholders via Schedule K-1 (Form 1120-S).
- C corporations file Form 1120 and are taxed separately from their owners.
Keep in mind that rules like basis, at-risk and passive activity limitations may restrict how much of a loss you can deduct in a given year.
How to determine your net operating loss to claim a business loss deduction
A net operating loss (NOL) occurs when a business’s allowable tax deductions exceed its taxable income within a given tax period. Essentially, it represents a financial loss for that period. Business owners can calculate their NOL by subtracting deductible business expenses, such as operating costs and depreciation, from their total taxable income. If the result is negative, you experienced a net operating loss for the year.
Calculating your NOL is important because it determines how much of that loss you can use to offset other income, either in the current year or future tax years. Accurately calculating and reporting your NOL ensures you claim the correct deduction, comply with IRS rules, and maximize potential tax savings.
There are limitations to the items you can deduct when calculating your NOL. In general, the following items are not allowed when figuring an NOL:
- Capital gains losses: Capital losses exceeding capital gains cannot be used to calculate NOL. This includes any nonbusiness capital losses reported through section 1202 exclusion.
- Nonbusiness deductions: Nonbusiness deductions in excess of nonbusiness income should also not be considered in the net operating loss.
- Carry back loss: Beginning with the tax year 2021, NOL can only be carried forward if it cannot be entirely claimed during the current tax year. Before tax year 2018, a taxpayer could take the loss for two years or forward or backward.
- Section 199A deductions: Exclude any amount claimed in the pass-through for qualified business income from your net operating loss.
Example of a business loss
Consider the following example of calculating net operating loss (NOL). Let’s say that your business has a total taxable income of $100,000 during the year. After reviewing your records, you find your expenses, like office space rental, utilities, business supplies, and marketing and advertising, total $120,000 in deductible expenses. To calculate the NOL, subtract the deductible expenses from the taxable income:
$100,000 (taxable income) – $120,000 (deductible expenses)
= -$20,000
In this scenario, the business incurred more expenses than it generated in taxable income; therefore, it has a net operating loss of $20,000.
What is the excess business loss limitation?
The Tax Cuts and Jobs Act (TCJA) sets limits on the amount of business losses you can deduct in a given tax year. For individual taxpayers, the maximum loss you can claim in a single tax year is $313,000 (or $626,000 for married taxpayers filing jointly).
An excess business loss occurs when the total business loss exceeds this threshold. The amount beyond the threshold is considered your excess business loss. The good news is that your excess business loss may be carried forward and claimed on a future tax return.
Can I deduct business losses from my personal income?
In many cases, business owners can deduct business losses from their personal income. The ability to do so depends on the legal structure of the business. For example, sole proprietors and owners of pass-through entities like LLCs and S corporations can typically use business losses to offset personal income.
However, several IRS rules may limit how much of those losses you can deduct. These include:
- Basis limitations, which restrict deductions to the amount you’ve invested in the business.
- At-risk rules, which limit losses to the amount you could actually lose financially
- Passive activity loss rules, which generally prevent losses from passive activities from offsetting active income.
In addition, the excess business loss limitation caps the total amount of business losses that can offset nonbusiness income in a given year, with any disallowed amount carried forward.
Can a business carry forward losses?
Yes! If your business experiences an excess loss, it should be reported on Form 461 to calculate the eligible portion for carry forward. Carrying forward a loss allows your business to find relief during challenging economic periods or startup phases when initial losses are common. However, it’s important to note that your carry forward loss is calculated differently than your net operating loss. For example, capital losses are not included in your net operating loss calculation. However, up to $3,000 of capital losses can be carried forward. Limitations are dependent on the type of loss incurred.
Before 2021, the IRS not only allowed you to carry forward a business loss, but you could also retroactively carry back a business loss. The “carry back” rule, which previously enabled businesses to offset current losses against past profits, has been eliminated. Generally, taxpayers cannot carry back any net operating loss reported after 2020.
Refer to the IRS website for more information and answers to frequently asked questions on carry back loss.
How much can I write off as a business loss?
The amount of business loss you can write off depends on various factors, including the type of business structure. For example, businesses can use net operating losses to offset taxable income in future years, providing a mechanism for carrying forward losses to optimize tax planning. The maximum amount you can claim in a single year is $313,000 for single filers or $626,000 for married taxpayers filing jointly.
Looking for more guidance? TaxSlayer Self-Employed offers small business owners all the right support for your unique tax situation.
