If you’re one of the many inventors who -- as of yet -- earns no money at all from inventing, you’ll have no taxes to pay on your inventing business. Only people who make money need to pay taxes. Likewise, no taxes will be due if your inventing expenses exceed inventing income. However, this doesn’t mean you need not be concerned with taxes. On the contrary, inventors who lose money have just as much to fear from the IRS as those who earn substantial profits.
Inventing business losses can be very valuable. You can use them to offset your income from other sources -- for example, a job or investment income -- and thereby reduce your tax liability for the year. However, the IRS and other tax agencies may closely scrutinize your deductions. To protect yourself in the event of an audit you should:
- be able to show the IRS that your inventing activities are a business, not a hobby
- keep accurate records of your expenses , and
- have a legitimate legal basis for your deductions.
Net Operating Losses
When losses from an inventing business are so great that they exceed an inventor’s total income for the year, the resulting loss is called a loss i “net operating loss,” NOL for short. Although it may not be pleasant to lose money over an entire year, having an NOL does result in important tax benefits -- indeed, it’s a little like having money in the bank because it can result in a quick tax refund.
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 an NOL 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 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.