Deducting Business Expenses in an Unprofitable Business
How Losses Work on a Business Tax Return
Making a profit should be a basic fact of business, but what if you aren't making a profit? Can you still deduct your business expenses? What if you make a small profit but your overall deductions amount to more? Can you still claim them?
You may be able to claim a business loss on your taxes, but in some cases it might be limited. This article discusses these situations.
What's Deductible If You Do Have a Business?
The more common case where a business has a loss relates to IRS regulations about limits to business losses. Losses from normal business operations are called operating losses.
The Internal Revenue Code says that business expenses must be "ordinary" and "necessary" to be deductible. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business; it doesn't have to be indispensable.
New Tax Law and Business Tax Losses
The Tax Cuts and Jobs Act, effective for 2018 and beyond, has several provisions that affect business losses.
Excess Loss Limits. The new law limits the amount of (non-corporate) business losses you can claim in a year. An excess business loss is an amount by which total business deductions are greater than a threshold amount (currently total gross income and gains plus $250,000 or $500,000 for a joint return).
Limit on NOL Deduction. There are limits to the amount of a net operating loss you can take in one year, for tax years after 2017. You can't take an NOL deduction for more than 80% of taxable income for a single year(for the 2018 tax year and beyond).
Elimination of Tax Carry-back. You previously had the ability to carry forward an excess business loss to a future year or to carry it back to a past year. The new law no longer allows the option to carry back a net operations loss (NOL).
Limits on Interest Expense Deductions. Businesses can deduct interest expenses as ordinary and necessary for your business, but the new tax law (Tax Cuts and Jobs Act) has a limit on the deduction you can take on interest. Your deductible business interest expense in a year can't be greater than the sum of:
- Your business interest income for the year; plus
- 30% of your adjusted taxable income (ATI) for the year, and
- Your floor plan financing interest expense for the year (this part is primarily for auto dealers).
Some small businesses are exempt from this limit.
How Business Expense Deductions Are Limited
There are several ways in which your business expense deductions can be limited for a tax year.
When Expense Deductions are Limited:
- Business expense deductions Aree limited:
- When your activity is determined to be not for profit (including hobby activity)
- When your ownership activity in the business is at risk (limited to the amount at risk),
- When your ownership in the business is passive (you don't materially participate in running the business),
- When your business has a net operating loss.
If your business is considered not-for-profit.
This is better known as the "hobby loss" case. You may have heard the term "hobby loss," referring to whether the IRS considers your operations as a not-for-profit business (that is, a hobby. The IRS looks at each situation to see if the activity is intended to make a profit, using nine factors and taking each situation on a case-by-case basis. If your activity is determined to be not-for-profit you must handle the expenses for this activity in a different way from a business:
- You can only deduct hobby expenses up to the amount of income for the year.
- If your hobby expenses are greater than your income, you can't deduct this loss from other income.
In addition, to deduct hobby expenses, you would previous have been able to itemize deductions on your personal tax return. The new tax law has eliminated the Miscellaneous Deductions" category from Schedule A, which eliminates your ability to deduct hobby expenses.
If your business activity is at risk
When the IRS looks at your participation in a business, it considers your participation in the business and whether your activity is at risk. Your share of the expense deductions and your personal loss from the business is limited to the investment you have at risk in the business. You are at risk:
- For the money and property, you contribute to the business (the adjusted basis is used to determine the property),
- If you are personally liable for repayment of amounts you borrow for business use, or
- If you pledge property as security for a business loan.
At-risk limits apply to individuals, including partners and S corporation shareholders, and shareholders of closely held C corporations.
If your business activity is passive.
Before you consider passive activity loss rules, you must first consider deductions allowed under the basis or at-risk rules.
Generally, the IRS doesn't allow a passive activity loss for a year. In other words, losses from passive activities can only offset income from passive activities. You can't deduct business expenses for more than the amount of your income and you can't use a loss from passive activities to offset other income.
A passive activity is a business or rental activity in which the person doesn't materially participate. Material participation means that the person participates in business activities on a regular, continuous, and substantial basis.
Some types of passive business income and losses are rental real estate, limited partnerships (where all partners are limited partners), and sole proprietorships, partnerships, S corporations, and LLCs in which the owner doesn't materially participate.
Passive income doesn't include income from salaries, portfolios, or investment income.
If you have a net operating loss.
If your business expense deductions for a year are more than your income for that you, you may have a net operating loss (NOL). The way you determine and deal with an NOL depends on your business type.
You take a net operating loss on your personal tax return if you are:
- A sole proprietor
- Partner in a partnership
- Member of an LLC (not taxed as a corporation)
- S corporation shareholder.
In these cases, the net operating law is divided between the owners based on their share of the business and reported on their personal tax return.
A corporation takes a net operating loss on its corporate tax return. Shareholders don't have an NOL personally.
Disclaimer: The details on how to deal with these different types of business losses are complicated. This article includes general information to give you an overview; it's not intended to be tax or legal advice. Every business situation is different, so be sure to talk to your tax professional before you consider the tax implications of business losses.
IRS. "Publication 535 Business Expenses. " What Can I Deduct? Page 1. Accessed Nov. 21, 2019.
IRS. "Instructions for Form 1045 Application for Tentative Refund." Accessed Nov. 21, 2019.
IRS. "Basic questions and answers about the limitation on the deduction for business interest expense." Accessed Nov. 21, 2019.
IRS. "Publication 535 Business Expenses." Limits on Losses, Page 6. Accessed Nov. 21, 2019.
IRS. "Publication 529 Miscellaneous Deductions." Accessed Nov. 21, 2019.
IRS. "Publication 925 Passive Activity and At-Risk Rules." At-Risk Limits, page 12. Accessed Nov. 21, 2019.
IRS. "Publication 535 Business Expenses. " How Much Can I Deduct? Page 2. Accessed Nov. 21, 2019.
IRS. "Passive Activity Losses - Real Estate Tips." Accessed Nov. 21, 2019.
IRS. "Publication 925 Passive Activity and At-Risk Rules." Passive Activity, Page 2. Accessed Nov. 21, 2019.
IRS. "Publication 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts." Introduction, page 2. Accessed Nov. 21, 2019.