Small business owners often have the ability to claim business losses on their personal tax returns, thereby reducing their obligations. This is generally true for businesses structured as sole proprietorships, limited liability companies (LLCs), partnerships and S corporations. However, there are a myriad of Internal Revenue Service (IRS) rules and limits governing the filing process. Read on to learn more.
Types of Business Losses
For small business owners, there are two types of business losses that can affect personal tax filings or small business taxes. The first, a capital loss, is associated with the sale or exchange of business property, such as a vehicle, a piece of equipment, or a building. It arises when the proceeds received for the property fall short of its adjusted book value.
The second type of loss, a net operating loss (NOL), is associated with normal business operations. It usually occurs when a business loses money, but calculating an NOL is not as simple as subtracting expenses from revenues. The process entails determining permissible tax deductions and applying them to income.
Both of these types of losses can impact your personal taxes, whether your business is structured as a sole proprietorship, an LLC, a partnership or an S corporation. See self employed tax deductions for other details. However, as you’ll see in the next section, the mechanics for reporting and claiming them varies slightly across legal structures.
Calculating and Reporting Business Losses
The process of calculating and reporting business losses can be very involved, and it’s easy to get overwhelmed with the details. So, as we delve into the process, keep the following milestone objectives in mind.
1. Determine capital losses (inclusive of carryforward credits)
2. Determine NOL (inclusive of carryforward credits)
3. Combine permissible amounts from the steps above and transfer the information to your annual tax filing – to maximize claimed losses and minimize your tax bill.
Maintaining a big picture perspective will help you make sense of the complexity.
Capital Losses
A capital loss arises when a business asset is sold or exchanged for less than its adjusted book value. For example, if a piece of equipment with an adjusted book value of $108,000 is sold for $100,000, the capital loss is $8,000.
From the business’ standpoint, the total loss negatively impacts the net income reported by the business to a full extent. However, on your personal taxes, you can only deduct the capital loss up to the amount of your capital gains or $3,000, if the net loss exceeds $3,000.
IRS Schedule D is the form used to report capital gains and losses with your tax filing. The following IRS bulletin contains instruction on how to use the schedule, along with broader guidance on handling capital gains and losses: IRS Resource on Capital Gains and Losses.
Net Operating Losses for Sole Proprietorships
The process for calculating and reporting an NOL associated with a sole proprietorship is very detailed. We can’t outline all of the steps and considerations without duplicating the tax code, but we can sketch out the broad strokes.
1. Use IRS Schedule C to report details on your business’ income and expenses. If the expenses exceed income, you have a business loss, and you can start the process of calculating an NOL.
2. Combine the business loss from Schedule C with any “other income” and “adjustments to income” on IRS Schedule 1.
3. Then, transfer the aggregated information to IRS Form 1040 to determine your adjusted gross income (AGI).
4. At this stage, you can take either the standard deduction or itemized deductions to reduce AGI.
5. Then, you must add back capital losses in excess of capital gains, non-business deductions in excess of non-business income and the qualified business income deduction, if applicable. If the result is a negative number, you have an NOL for the year – subject to IRS-imposed limits (discussed later in this guide).
6. The previous five steps facilitate the completion of Form 1040, which summarizes all pertinent personal tax information for the year, including your obligation. See form 1040 schedule C instruction for more details.
While accurate, the aforementioned sequence of events is very simplistic. Other underlying steps, schedules and forms often come into play, depending on the situation. For comprehensive IRS instruction, see Publication 536: Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.
Net Operating Losses for Pass-through Entities
The steps outlined above pertain to sole proprietorships. If your business is operated as an LLC, partnership or S corporation, your share of the business' loss is passed through to you for reporting at the individual level.
The loss can then be deducted from your other personal income and filed via Form 1040 in much the same way as done with a sole proprietorship. The primary procedural difference is that your share of the business’ loss should be reported on IRS Schedule E, rather than Schedule C.
Note:
Business losses associated with sole proprietorships and pass-through entities can generally be deducted from personal income on your taxes. However, losses associated with C corporations are tied to the business. They cannot be reported on an individual tax return.
Business Loss Limits and Rules
Both capital losses and net operating losses may be limited for a specific tax year. The limitations pertain to business owners and their individual returns, not the businesses themselves.
Capital Loss Limits and Rules
With regard to capital losses, a business owner can only claim a business’ capital loss to the extent of his or her individual capital gains or $3,000, if the net loss exceeds $3,000. Any remaining capital loss can be carried forward for application in future years.
NOL Limits and Rules
With regard to NOLs, the IRS rules are much more complicated than those for capital losses. They are best viewed collectively – as levels of the following four-part framework:
1. The tax basis rule ensures that an individual’s investment interest in a company is equal to or in excess of any loss claimed. A business owner cannot deduct a loss in excess of his or her basis.
2. The at-risk rule limits the claimable amount of a business loss to the net allowable business deductions for the year, inclusive of depreciation and tax amortization. Essentially, this prevents a taxpayer from deducting amounts that exceed total business expenses.
3. The passive activity rule requires a taxpayer to materially participate in an activity in order to deduct losses associated with it. If a taxpayer does not materially participate in the activity, the loss is deemed passive and is only deductible against other passive sources of income.
4. The excess business loss rule limits the ability of taxpayers to claim business losses against other sources of income, such as wages and investment income. It kicks in when total business deductions are more than total gross business income, above a threshold amount. For 2022, the threshold is $270,000 for a single taxpayer ($540,000 for a joint return)
You’d think the restraints above were enough, but the IRS maintains one more restriction. It limits the extent to which a taxpayer can utilize an NOL to 80% of modified taxable income in any given year. Any excess may be carried forward and deducted in future years.
As a final consideration, please know that the IRS is wary of a business that generates NOLs year over year. Generally, over any five-year period, you can claim a business NOL for up to two of those years, without any tax problems. If you claim a business loss more frequently, the IRS could deem your business to be a hobby, which limits the deductibility of losses.
Note:
All of this information pertains to the 2021 tax year and beyond. For prior years, a number of recent legislative acts, including the Tax Cuts and Jobs Act (TCJA) and the Coronavirus Aid Relief and Economic Security Act (CARES Act), necessitate different tax treatment. If you are looking for guidance on a tax return prior to 2021, consult with a tax professional.
Conclusion
The process for calculating and reporting business losses is very detailed and entails a comprehensive understanding of the U.S. tax code. While it is possible to file your own taxes, the complex and ever changing nature of the code prompts most business owners to enlist tax professionals. Unless you’re an accountant or a well-versed financial professional, think twice before going it alone. You face too much risk, mostly upside (missing deductions and credits), but also downside (getting hit with penalties).
Sources:
Internal Revenue Service. (2022, March 1). About Form 1040, U.S. Individual Income Tax Return. Retrieved from https://www.irs.gov/forms-pubs/about-form-1040
Internal Revenue Service. (2022, March 1). About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship). Retrieved from https://www.irs.gov/forms-pubs/about-schedule-c-form-1040
Internal Revenue Service. (2021, July 15). About Schedule D (Form 1040), Capital Gains and Losses. Retrieved from https://www.irs.gov/forms-pubs/about-schedule-d-form-1040
Internal Revenue Service. (2021, July 15). About Schedule E (Form 1040), Supplemental Income and Loss. Retrieved from https://www.irs.gov/forms-pubs/about-schedule-e-form-1040
Internal Revenue Service. (2022, January 7). Definition of Adjusted Gross Income. Retrieved from https://www.irs.gov/e-file-providers/definition-of-adjusted-gross-income
Internal Revenue Service. (2022, February 28). Publication 536: Net Operating Losses (NOLs) for Individuals, Estates, and Trusts. Retrieved from https://www.irs.gov/pub/irs-pdf/p536.pdf
Internal Revenue Service. (n.d.). Schedule 1 (1040): Additional Income and Adjustments to Income. Retrieved from https://www.irs.gov/pub/irs-pdf/f1040s1.pdf
Internal Revenue Service. (2022, May 19). Topic No. 409 Capital Gains and Losses. Retrieved from Irs.gov.
