Business Losses and Your Personal Taxes
Your small business may have several types of losses, depending on the type of income. These include:
Net operating losses from normal business operations Capital losses on the sale or exchange of business property
Both types of losses affect your personal income taxes because most small businesses pay taxes through their personal tax return. These types of businesses include sole proprietorships, limited liability companies (LLCs), partnerships, and S corporations. A business loss from operations can offset other income to give the owner a lower tax bill. For example, a business owner’s Schedule C might show an operating loss of $10,000, and the owner’s other taxable income is $45,000. If the total amount of the business loss is allowed, the owner’s net taxable income would be $35,000. Capital losses result from the sale or exchange of a capital asset, like a business vehicle, equipment, or a building, or an intangible asset like a patent or license. You can only deduct the amount of losses up to the amount of the capital gains (or $3,000 if the net loss exceeds $3,000).
Deductible Business Expenses
Most small businesses intend to make a profit and are at risk for losses, so they may take all ordinary and necessary business expenses to determine operating profit or loss. These expenses include:
Advertising and promotion Expenses related to having employees Fees to professionals and other non-employees Insurance Interest on loans Office expenses Cost of company vehicles and travel Home office expenses Cost of goods sold (COGS) for businesses that sell products
Capital expenses for costs of long-term assets like vehicles, equipment, and furniture are also deductible by spreading out the cost over several years through depreciation.
Limits on Business Losses
Both operating losses and capital losses may be limited for a specific tax year. These loss limitations are applied to business owners, not the businesses themselves.
Net Operating Loss
If your total deductions for a year, including business tax deductions, are more than your total income for a year, you may have a net operating loss (NOL), which is limited to 80% of the individual’s excess taxable income for that year. The excess loss is calculated by starting with the business net income for the year and subtracting any of these non-allowed deductions and losses:
Capital losses in excess of capital gains Gain from the sale or exchange of qualified small business stock Nonbusiness deductions in excess of non-business income The net operating loss deduction The qualified business income (Section 199A) deduction
Losses from At-Risk and Passive Activities
Business losses may also be limited from at-risk and passive activities may also affect the amount of business loss you can take. Passive activity means that the business owner didn’t actively participate in managing the business on a regular, continuous, and substantial basis. For example, an owner who rents real estate is considered a passive owner, even if they do participate in management, while a limited partner in a partnership is considered a passive investor. At-risk rules limit the amount of business loss to the net allowable deductions for the business for the year, including depreciation and tax amortization.
How Loss Carryforward Works
If your net operating loss for a year is limited, you may be able to use all or part of that loss in future tax years through a process called loss carryforward. The amount carried forward is the excess of your NOL deduction over your modified taxable income for the year, subject to the 80% limit for 2021 and beyond. You can’t claim an NOL deduction for the NOL carryover for the current or any later NOL, and your modified taxable income can’t be less than zero. The calculations for net operating loss and loss carryforward are complicated. Get help from a licensed tax professional for this part of your tax return.
How To Claim Your Losses
Net income is calculated by adding up all sources of income and subtracting deductions and credits. Complete Schedule C (or other tax form for your business type) and enter the net profit or loss on Schedule 1 of Form 1040 or 1040-SR (for seniors). The information from Schedule 1 is added to income from other sources, and any adjustments to income are included in Schedule 1. You must also complete IRS Form 461 Limitation on Business Losses. This form adds up all types of losses from various sources, including operating losses and capital losses, adjusts for non-business losses, and runs a calculation for excess business losses. Because you are in business to make a profit, several years of loss can be a red flag for the IRS. The IRS guidelines presume you are in business to make a profit if you have a profit in at least three of the last five tax years. If you can’t meet this test, the IRS may consider your activities a hobby, not a business, and you may not be able to take business tax deductions. First, check to see if your losses might be limited because you might be a passive owner, meaning that you don’t participate actively in your business. This is typically the case for limited partners in a partnership or individuals in rental real estate businesses. Once you have your net operating loss, you can include all the information about your business losses on your Form 1040. If you can’t take all of your loss for the year, you may be able to carry some of that loss over to future years, through a process called loss carryforward. This is a complicated process, so you should get help from a licensed tax professional.
