Unfortunately, businesses don't always earn a profit. A fact that is especially true as you're just starting your business or if economic conditions are poor. Let's walk through what to do if your business loses money. We'll also talk about how small business losses may be tax deductible.
Yes, you may deduct any loss your business incurs from your other income for the year if you're a sole proprietor. This income could be from a job, investment income or from a spouse's income.
A limited liability company (LLC), S corporation, or partnership may also deduct a business loss. Yet, if you operate your business through a C corporation, you can't deduct a business loss on your personal return. Those losses belong to your corporation.
If your losses exceed your income from all sources for the year, you have a "net operating loss." While it's not pleasant to lose money, a net operating loss can provide crucial tax benefits. It may be used to reduce your tax liability.
Figuring the amount of a net operating loss is not as simple as deducting your losses from your annual income. First, you must determine your annual losses from your business (or businesses). Find this by tallying your business expenses and comparing it to your reported business income.
Add your business loss 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 a net operating loss, 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). The amount must be a negative number, or you won't have a net operating loss 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 a net operating loss for the year.
You can use Schedule A of IRS Form 1045, Application for Tentative Refund, to calculate a net operating loss.
There's no limit to how many years your operation can take a loss. Most businesses can't assume a loss for multiple consecutive years because their money tends to run out. However, if you can comfortably cover your costs and sustain your lifestyle, there's nothing wrong with maintaining a loss on your business year-over-year. In fact, we'll talk about some of the advantages of this below.
While, a continual loss for many, many years may cause some harder looks from the IRS. Actually, it may classify your business as a hobby if there's no material advancement toward a profit motive.
You can no longer carry an NOL back for two years thanks to tax reform. Although, you can still carry a net operating loss forward.
You have the option of applying your net operating loss 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. You elect to carry a loss forward by attaching a written statement to your tax return for the year you incur the NOL.
To find out more about net operating loss refer to IRS Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.
You need to make sure your activity is an actual business. That is, it's something you regularly and continuously engage in primarily to earn a profit.
The IRS expects your business to make a profit eventually. It understands that there are ups and downs, though. If your company hasn't turned a profit in at least three of the previous five years, it may face being considered a hobby. Under those circumstances, hobby expenses and losses have limited tax advantages.