How to Deduct Business Losses and Net Operating Losses
Don't miss out on the tax relief available for business losses, including net operating losses.
Businesses don’t always earn a profit. This is particularly likely to occur when they are first starting out or when economic conditions are bad. If you’re in this unfortunate situation, you may be able to obtain some tax relief. This could provide you with a refund of all or part of previous years’ taxes in as little as 90 days—a quick infusion of cash that should be very helpful.
If, like most small business owners, you’re a sole proprietor, you may deduct any loss your business incurs from your other income for the year—for example, income from a job, investment income, or your spouse’s income (if you file a joint return). If your business is operated as an LLC, S corporation, or partnership, your share of the business’s losses are passed through the business to your individual return and deducted from your other personal income in the same way as a sole proprietor. However, if you operate your business through a C corporation, you can’t deduct a business loss on your personal return. It belongs to your corporation.
If your losses exceed your income from all sources for the year, you have a “net operating loss” (NOL for short). While it’s not pleasant to lose money, an NOL can provide important tax benefits: It may be used to reduce your tax liability for both past and future years.
Figuring a Net Operating Loss
Figuring the amount of an NOL is not as simple as deducting your losses from your annual income. First, you must determine your annual losses from your business (or businesses). If you’re a sole proprietor who files IRS Schedule C, the expenses listed on the form will exceed your reported business income. If your business is a partnership, LLC, or S corporation shareholder, your share of the business’s losses will pass through the entity to your personal tax return. Your business loss is added to all your other deductions and then subtracted from all your income for the year. The result is your adjusted gross income (AGI).
To determine if you have an NOL, you start with your AGI on your tax return for the year reduced by your itemized deductions or standard deduction (but not your personal exemption). This must be a negative number or you won’t have an NOL for the year. Your adjusted gross income already includes all the deductions you have for your losses. You then add back to this amount any nonbusiness deductions you have that exceed your nonbusiness income. These include the standard deduction or itemized deductions, deduction for the personal exemption, nonbusiness capital losses, IRA contributions, and charitable contributions. If the result is still a negative number, you have an NOL for the year. You can use Schedule A of IRS Form 1045, Application for Tentative Refund, to calculate an NOL.
Carrying a Loss Back
You may apply an NOL to past tax years by filing an application for refund or amended return for those years. This is called carrying a loss back. (IRC Sec. 172.) As a general rule, it’s advisable to carry a loss back, so you can get a quick refund from the IRS on your prior years’ taxes. However, it may not be a good idea if you paid no income tax in prior years, or if you expect your income to rise substantially in future years and you want to use your NOL in the future when you’ll be subject to a higher tax rate.
Ordinarily, you may carry back an NOL for the two years before the year you incurred the loss. However, the carry-back period is increased to three years if the NOL is due to a casualty or theft, or if you have a qualified small business and the loss is in a presidentially declared disaster area. (A qualified small business is a sole proprietorship or partnership that has average annual gross receipts of $5 million or less during the three-year period ending with the tax year of the NOL.) The carryback period for a farming business loss is five years.
The NOL is used to offset the taxable income for the earliest year first, and then applied to the next year or years. This will reduce the tax you had to pay for those years and result in a tax refund. Any part of your NOL left after using it for the carry-back years is carried forward for use for future years.
There are two ways to claim a refund for prior years’ taxes: You can file IRS Form 1040-X, Amended U.S. Individual Income Tax Return within three years, or you can seek a quicker refund by filing IRS Form 1045, Application for Tentative Refund. If you file Form 1045, the IRS is required to send your refund within 90 days. However, you must file Form 1045 within one year after the end of the year in which the NOL arose.
Carrying a Loss Forward
You have the option of applying your NOL only to future tax years. This is called carrying a loss forward. You can carry the NOL forward for up to 20 years and use it to reduce your taxable income in the future. When you do this, you must attach a statement that includes a computation showing how you figured the NOL deduction. If you deduct more than one NOL in the same year, your statement must cover each of them.