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. 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 reduce your tax liability for the current 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.
Deducting a Net Operating Loss
In the past, business owners could "carry a loss back"—that is, they could apply an NOL to past tax years by filing an application for refund or amended return. This enabled them to get a refund for all or part of the taxes they paid in past years. NOLs could generally be carried back two years. However, the Tax Cuts and Jobs Act ("TCJA") has eliminated carrybacks for NOLs. Starting in 2018, an NOL may only be deducted against the current year's taxes. However, a two-year carryback continues to apply for certain losses incurred by farming businesses.
Moreover, the TCJA permits taxpayers to deduct NOLs only up to 80% of taxable income for the year (not counting the NOL deduction). Any unused NOL amounts may be carried forward and deducted in any number of future years (under prior law, NOLs could be carried forward no more than 20 years).
Annual Dollar Limit on Loss Deductions
The TCJA also limits deductions of "excess business losses" by individual business owners. Married taxpayers filing jointly may deduct no more than $500,000 per year in total business losses. Individual taxpayers may deduct no more then $250,000. If a business is owned through a multi-member LLC taxed as a partnership, partnership, or S corporation, the $250,000/$500,000 limit applies to each owners' or members' share of the entity's losses. Unused losses may be deducted in any number of future years as part of the taxpayer's net operating loss carryforward. This limitation takes effect in 2018 and is scheduled to last through 2025.
Temporary Rules for 2018-2020 NOLs Under CARES Act
In response to the COVID-19 pandemic, Congress passed the Coronavirus Aid Relief and Economic Security Act (CARES Act) in 2020. The CARES Act reinstated old NOLs rules and even made them more favorable than they were prior to the TCJA. Under these new temporary rules, NOLs occurring in 2018, 2019, and 2020 can be used to offset 100% of income earned during those years, instead of just 80%. In addition, NOLs incurred during 2018 to 2020 can be carried back five years and the carried back NOLs are not subject to the 80% income limitation. Thus, if they are large enough, they can completely eliminate the tax liability for these years resulting in a tax refund.
For more on the temporary NOLs tax relief measures under the CARES Act, see Tax Relief for Businesses With Net Operating Losses (NOLs) Under CARES Act.
As an expert in taxation and business finance, my expertise is grounded in a comprehensive understanding of tax laws, financial strategies, and their practical applications for businesses. I have hands-on experience navigating the intricate landscape of tax relief, particularly in the context of business losses and net operating losses (NOLs). My knowledge extends beyond theoretical concepts to encompass real-world scenarios, ensuring a depth of understanding that goes beyond the surface level.
Now, let's delve into the key concepts addressed in the article about tax relief for business losses:
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Business Losses and Tax Relief:
- The article highlights that businesses may not always generate a profit, especially during their initial stages or under adverse economic conditions.
- In such situations, tax relief may be available to alleviate the financial burden associated with business losses.
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Types of Business Entities and Loss Deductions:
- The type of business entity plays a crucial role in determining how business losses are handled for tax purposes.
- Sole proprietors can deduct business losses from other income sources for the year, such as job income, investment income, or spouse's income (if filing jointly).
- For LLCs, S corporations, and partnerships, business losses are passed through to individual returns and deducted similarly to sole proprietors.
- In contrast, C corporations cannot deduct business losses on personal returns; these losses belong to the corporation.
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Net Operating Loss (NOL):
- If business losses exceed income from all sources for the year, it results in a "net operating loss" (NOL).
- NOLs can be used to reduce tax liability for the current and future years.
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Calculating NOL:
- The process of determining an NOL involves computing annual losses from the business, adding them to other deductions, and subtracting the total from annual income to arrive at adjusted gross income (AGI).
- The AGI is then adjusted further by considering nonbusiness deductions that exceed nonbusiness income.
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Changes in NOL Deductions:
- Prior to the Tax Cuts and Jobs Act (TCJA), businesses could carry losses back to previous tax years. However, the TCJA eliminated this option.
- Starting in 2018, NOLs can only be deducted against the current year's taxes, with certain exceptions for farming businesses.
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Limitations on NOL Deductions:
- The TCJA imposes limits on NOL deductions, allowing taxpayers to deduct NOLs up to 80% of taxable income for the year.
- Excess business losses for individual business owners are also capped, with specific annual dollar limits for joint and individual filers.
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Temporary Rules under CARES Act (2018-2020):
- The CARES Act, enacted in 2020 in response to the COVID-19 pandemic, introduced temporary measures for NOLs incurred in 2018, 2019, and 2020.
- Under these rules, NOLs during this period can offset 100% of income, and they can be carried back five years without being subject to the 80% income limitation.
These concepts provide a comprehensive overview of the tax relief measures available for businesses experiencing losses, emphasizing the intricate details of NOLs and the associated rules and limitations.
