Claiming Business Losses on Your Tax Return
Let's say you have a loss in your business for the year. Can you get a tax refund for that loss? Can you take the loss to reduce your personal taxes? Getting some tax benefit from your business loss depends on the legal type of business you own and whether your investment in the business is "at risk" in whole or in part. It also depends on whether you have other income.
Limits on business losses are different for corporations vs. other business types that have pass-through taxation (that is, their business profits and losses are included with their personal tax return). Pass-through businesses include sole proprietors, LLCs, partnerships, and S corporations.
How to Calculate Your Business Loss
Some businesses that have a loss can claim that loss to reduce their taxes, with certain limits.
To calculate the amount of the loss, you add your business income and subtract business expenses on your business tax return. If your deductible expenses are greater than the income, you have a loss, and you can start the process of calculating a net operating loss (NOL). As it says, this is a loss on your business operations, not investments.
To run this NOL calculation, you can take some deductions in full, like rent or office expenses. Other deductions, for depreciation or home business costs, are limited. The total amount of your loss may be limited in one year. In that case, you may be able to take that loss in a previous year (called a loss carryback) or a future year (called a loss carryforward).
Business losses result when expenses are greater than income. You may be able to take all or part of your business loss for a year to offset other income, to reduce your overall taxes.
New Tax Law Changes for Business Losses
The 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES Act) made several changes to tax laws to ease the burden on businesses affected COVID-19. These changes affect business taxes in 2018, 2019, and 2020. Business loss rules from the previous law, the 2017 Tax Cuts and Jobs Act (TCJA), will be restarted in 2021.
- The CARES Act removed the limit on business losses for small businesses (not corporations); that is, there are no limits to how much business loss you can take for the year. The IRS says you can file an amended tax return for 2018 and/or 2019 if your business losses were limited for those years.
- It also allows businesses to carry back losses from 2018, 2019, and 2020 to previous years against income from those years.
- Finally, your small business (not corporations) may use net operating losses to offset your personal income with no limit.
Previous Law Changes for Business Losses
The 2017 Tax Cuts and Jobs Act made several significant changes to the way business losses are handled:
The tax loss carry back is no longer available. You can still carry a business loss forward to future tax years, but you can no longer carry a net operating loss back to past years.
The amount you can carry forward is also limited to 80% of taxable income, but you can go forward for an unlimited number of years. Tax loss carryforwards are not available to corporations.
The IRS changed the limits on excess business losses (see below) based on the total income of the taxpayer. Loss limits don't apply to corporations. In other words, you can't write off (deduct) business losses if they are too large.
Types of Businesses and Excess Business Losses
Excess loss limits only apply to businesses that are not corporations. These business types are:
- Sole proprietors and one-owner LLCs (called single-member LLC) that calculate business taxes on Schedule C as part of the owner's personal tax return
- Partnerships and multiple-member LLCs that calculate business taxes on a partnership tax return, with income passing through to the individual partners
- S corporations that calculate business taxes on Form 1120S, with income passing through to individual owners
What is Excess Loss?
The limits on excess business losses have been dropped for 2018, 2019, and 2020 taxes. They will be effective again for 2021 taxes.
The IRS says you have an excess loss if your total business deductions are more than your total gross income and your business profits, plus $250,000, or $500,000 for a joint return.
To say it more simply, taking any loss more than $250,000 (single taxpayer) /$500,000 (joint return) is considered excess and that excess amount can't be taken as a loss on your tax return for the year.
How Excess Loss Limit Works: Examples
Let's say Pam (a single taxpayer) had a business loss of $125,000 this tax year. Since it was less than $250,000, she can take the full $125,000 of loss on her tax return this year.
Now let's say Tom (a single taxpayer) has a business loss for the year of $325,000. This amount is greater than the $250,000 limit, so he can only take $250,000 of loss on this year's return, leaving $75,000 of loss that he might be able to carry forward to the next tax year or beyond.
These examples are over-simplified. The calculation of excess business loss is complicated, and other factors on an individual tax return, including at-risk rules and passive activity rules (explained below) may affect the excess loss.
Determining Excess Loss - Steps
Your total income and losses from all business and personal sources are collected on your personal tax return. You must calculate your net operating loss (the loss from normal business operations) using specific IRS methods.
Before you calculate the excess business loss, you must first apply (1) at-risk rules and then (2) passive activity rules.
At-risk rules limit your losses from business to your amount at risk in the activity. These at-risk limits apply to partners and S corporation shareholders and certain closely-held C corporation owners. At-risk rules also apply to specific types of business.
If your business is a sole proprietor or single-member LLC filing your business tax return on Schedule C, you'll need to use IRS Form 6198 to compute and report your at-risk situation.
Passive activity also limits business loss deductions. Business losses may be limited if they result from what the IRS calls "passive activity," that is, a business in which the owner does not participate on a regular, continuous, or substantial basis. Losses resulting from passive activity can only be deducted up to the amount of income from that business.
After those rules have been applied, you can consider how much loss you can take for the year. The form used to calculate this loss in IRS Form 461: Limitation on Business Losses. The information needed for the calculation is on this form. It assumes you are filing a 1040 form for your personal taxes.
If your business loss for the year is greater than the loss allowed for the year because it is over the excess loss limit, you may be able to carry forward the excess loss to a future tax year.
See the instructions for Form 6198 for more information, or check with your CPA or tax advisor. It is one section you don't want to try by yourself unless you are positive you know what you are doing.
Partnerships, LLCs, and S Corporations
Partners in partnerships, LLC members, and S corporation owners pay tax on their share of the profits of the business. They can also offset losses, up to the amount of their investment "basis" in the business. See this IRS article with answers to common questions about partnership losses.
How Capital Losses May Be Limited
For capital losses passed through to your personal tax return: If your capital losses are greater than your capital gains, you can claim the excess loss if it is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss on Form 1040 Schedule D.
The IRS regulations on business losses are complicated. The information in this article is a brief overview, not intended to be tax or legal advice. Get the help of a tax professional who is experienced with business activities.
IRS. "Limitation on Business Losses for Certain Taxpayers Repealed for 2018, 2019, and 2020." Accessed July 27, 2020.
Tax Foundation. "A Review of Net Operating Loss Tax Provisions in the CARES Act and Next Steps for Phase 4 Relief." Accessed July 28, 2020.
IRS. "The Highlights of Tax Reform for Businesses." Accessed July 28, 2020.
IRS. "IRS Highlights Tax Reform Changes That Affect Businesses." Accessed Dec. 12, 2019.
IRS. "Excess Business Losses." Accessed Dec. 12, 2019.
IRS. "Publication 925: Passive Activity and At-risk Rules," Page 2. Accessed Dec. 12, 2019.
IRS. "Topic No. 407 Business Income." Accessed Dec. 12, 2019.
IRS. "Topic No. 409 Capital Gains and Losses." Accessed Dec. 12, 2019.