Businesses exist to make money, not to lose it, but in some years, taking a loss just can’t be helped. When that happens, business owners have different options, based on how the company is structured, how its past financial statements look and what it expects to see in its near future. The Internal Revenue Service allows a business to use these losses to reduce current, past and future tax liabilities – to a point.
Individual Returns
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Many small businesses, especially those just launching, are structured in ways that allow their owners and shareholders to incorporate business losses into their personal filings. A sole proprietor pays business taxes along with her individual tax return, including its income along with her own on her annual 1040 form. If her business suffers a loss, it’s deducted from her other income during the year, or income from other family members on a joint return. Businesses operating as an LLC, S corporation or partnership operate in similar fashion, with profit and loss taken on the personal returns of shareholders rather than on a return for the business as its own entity.
Pay It Forward (Or Back)
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If your business losses exceed all of your income from all your other sources, you’re operating at a net operating loss, often abbreviated to NOL. This occurs when your losses declared on your Schedule C form as a sole proprietor, or the amount passed through to your personal return from an LLC, S corp or partnership, leaves you with a negative adjusted gross income. Add back any nonbusiness deductions that exceed your AGI, such as from personal exemptions, charitable donations or nonbusiness capital losses. If that number is still negative, you can carry the loss back for up to two years, applying for a refund or filing an amended return and taking the remaining loss off of that income. You can also carry a loss forward for up to 20 years.
C Corporations
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In a C corporation, losses belong to the corporation rather than an individual. Therefore, it can’t pass losses to its shareholders to pass through on their individual returns. Instead, a C corporation must carry the losses back against previous gains or forward until it has enough income to deduct the previous year’s losses. Any carryover amount has to be listed on the company’s Schedule K form. A C corporation also is allowed to ask for an extension to pay its current year’s taxes if it expects an NOL in the following year by filling out IRS Form 1138.
Pressure for Profit
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The IRS doesn’t allow a business to claim a loss forever. The general rule is that your operation qualifies as a business if it shows a profit three times in a five-year period. Otherwise, it’s considered a hobby, resulting in different treatment at tax time. If your business is your sole or primary source of income, the IRS also may take a closer look at your return if it shows losses too often, wondering how you’re maintaining your standard of living with negative income. Keeping detailed records that prove the business losses can help support your case should the IRS choose to audit your return.
