How Business Losses Work to Offset Income
Business Losses for Sole Proprietors, Partnerships, LLC's
Let's say you have a loss in your business for the year. Can you get a tax refund for that loss? Getting some 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.
In this article, we will look at how losses are determined for different business types and how they affect taxes for the business owners.
First, I'll explain in general and then I'll give you the details for businesses that have pass-through taxation (that is, their business profits and losses are included with their personal tax return).
Business Losses for Corporations
Owners of a corporation are not taxed directly on business profits and losses because the corporation's taxes are separate from those of the business owners. The owners of a corporation are shareholders ; they are taxed on distributions (dividends). No dividends, no taxes due.
Business Losses for Pass-through Entities
As discussed above, for some types of businesses, business income and loss passes through to the owner's personal tax return. These business types are:
- Sole proprietors and one-owner LLC's (called single-member LLC) that calculate business taxes on Schedule C, and
- Partnerships, S corporations, and multiple-member LLC's that calculate business taxes on a partnership tax return.
Determining Net Operating Loss
Your total income and losses from all business and personal sources are collected on your personal tax return. A net operating loss can be calculated, using specific IRS methods. If you have a net operating loss, you may be able to get a refund on your personal tax return.
Net operating loss is calculated by using Adjusted Gross Income on line 37 of Form 1040 and subtracting standard or itemized deductions (but not subtracting personal exemptions. More details on net operating loss are available in IRS Publication 536.
Net operating loss is calculated on Schedule A of IRS Form 1045 (PDF). The title of this form includes the term "Tentative Refund." This refund is actually a requirement that you move the loss to a previous tax year in which you had a profit. This is called a "loss carry back" (described below).
At-Risk Rules and Business Losses
At-risk rules limit your losses from a 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 This is very complicated. You will need a competent tax expert to sort it out.
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.
For details, see IRS Publication 925.
Sole Proprietorship and Single-member LLC
A sole proprietorship is taxed through the business owner's personal tax return (Form 1040 and its variants). The business owner fills out Schedule C by showing the income and deductible expenses of the business. At the end of this form, on Line 31, the net profit or loss of the business is shown. If there is a profit, this number is transferred to Line 12 of Form 1040.
As discussed above, if your business has a loss, you must determine if all of your investment in the business is "at risk." The investments of most business owners are at risk; investments that are not at risk include "stop-loss" or "non-recourse" loans. If all of the activity of your business is at-risk, you can deduct the full amount of the business loss.
See the instructions for Form 6198 for more information, or check with your CPA or tax advisor. This is one section you don't want to try by yourself, unless you are positive you know what you are doing.
Partnerships, LLC's, and S Corporations
If your business is a multiple-member LLC, a partnership, or an S corporation, you can also offset losses, up to the amount of your investment "basis" in the business. It is easiest to look at an example to see how this works:
- Jim and Tom are partners in a small consulting firm. They both put $10,000 into the business and are sharing profits and losses 50/50. They also took out a loan for $30,000 for startup. The initial basis for each partner is $20,000 ($5,000 plus $15,000).
- The first year, they had income of $5,000 and expenses of $25,000, for a loss of $20,000. They split the loss 50/50, so each has a loss of $10,000. Since they have a $15,000 basis, they can each take their full share of the loss to offset other personal income for the year.
- This leaves Jim and Tom with a basis of $5,000 the next year, unless they take out other loans or add to their investment. If their loss is greater than $5,000 each, they can only take the loss up to the $5,000.
Deducting Losses in Past or Future Years
If you have business losses that are not deductible in the year when you have the loss, you may be required to or choose to deduct these losses in past or future years. This is called a tax loss carry back or loss carry forward, and again, it's something you must get a tax professional to help you with.
A disclaimer: As usual, with tax issues, this subject is more complicated than it might seem. The information in this article, and on this site, is for general purposes only. It is not intended to be tax or legal advice. To calculate net operating loss and other calculations for your tax return, you will need the help of an experienced tax professional.