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Experiencing a net loss can be difficult for any business, but it’s not uncommon, especially for new companies. The good news is that filing a tax return with a net loss can open up tax benefits, including deductions and credits that may help reduce your future tax burden. Here’s a detailed guide on how to file your tax return when your business has a net financial loss for the year, and how to make the most of any tax relief options available.

Understanding Net Operating Loss (NOL) Rules

When a business incurs a net loss for the year, it may qualify for a Net Operating Loss (NOL), which can be applied to reduce taxable income in future profitable years. This NOL can be a powerful tool for improving your long-term financial outlook.

An NOL occurs when a business’s deductions exceed its income in a given tax year. This excess can be carried forward to offset future taxable income, helping to lower tax liabilities. NOLs can offset up to 80% of taxable income in future years. This means that even if your NOL amount is large, it can’t entirely erase your taxable income if you turn a profit in the future, but it can reduce it substantially.

Recent tax law changes limit the ability to carry NOLs backward. For losses incurred in tax years after 2020, NOLs can only be carried forward (not back to previous years), though they can be carried forward indefinitely.

Deducting Losses on Your Tax Return

Filing a tax return with a net business loss allows you to take deductions that reduce taxable income. For sole proprietors, partnerships, and S corporations, these losses pass through to personal tax returns, potentially reducing personal income tax as well.

• Form 1040 (Schedule C or Schedule F for Sole Proprietors): Sole proprietors report business income or losses on Schedule C or Schedule F (for farming businesses) of Form 1040. If you have a net loss, it can reduce your total taxable income on your personal return.
• Partnerships and S Corporations: Losses in these entities are passed on to the partners or shareholders, who report them on their personal returns. This can decrease the individual’s taxable income, but keep in mind that the IRS limits how much loss can be claimed based on the at-risk and passive activity rules (see below).
• Corporations: C corporations report business losses directly on their tax return (Form 1120), which impacts the corporation’s taxable income. Losses in a C corporation do not affect personal income taxes but can provide carryforwards for corporate tax savings in profitable years.

Navigating At-Risk and Passive Activity Rules

When claiming a net loss on your tax return, you must comply with IRS rules related to risk levels and activity types. These restrictions limit how much loss you can apply to reduce taxable income.

At-Risk Limits: The at-risk rule requires that your investment in the business is genuinely “at risk” – meaning you could lose it if the business fails. If your investment is protected from personal loss (e.g., through nonrecourse loans), your deductible losses may be limited.

Passive Activity Loss Rules: For business owners not actively involved in daily operations, losses may be classified as passive and are only deductible to the extent of passive income from other sources. Active participation in your business, such as making management decisions, can help avoid these restrictions and maximize deductible losses.

Complying with these rules ensures that your losses are accurately represented and prevent potential issues if the IRS reviews your return.

Using Carryforwards to Offset Future Profits

One of the most advantageous options when filing with a net loss is the ability to carry forward losses. This allows you to use your current year’s losses to offset income in future profitable years, which can reduce your future tax obligations significantly.

• Carryforward Rules: As noted, NOLs generated after 2020 are subject to an 80% limit on taxable income and can no longer be carried back to prior years. However, they can be carried forward indefinitely, offering long-term tax benefits as your business grows.
• Example of a Carryforward: Suppose your business has a $50,000 loss in 2023. In 2024, if your business generates a taxable income of $40,000, you can apply up to $32,000 (80%) of the carryforward loss to reduce that taxable income, effectively lowering your taxable income for 2024 to $8,000.

Applying losses to future returns requires keeping clear and accurate records. Consulting a tax professional can help you ensure carryforwards are applied correctly and at the optimal time.

Seek Guidance from a Tax Professional

Filing a tax return when your business has a net loss can be complex, especially with carryforwards and deductions to consider. A tax professional can help ensure that you’re taking full advantage of any tax benefits available while remaining compliant with IRS rules.

As the financial year draws to a close, if you believe you may be facing a financial loss in your business, contact Demian & Company CPAs. We’ll sit down with you to discuss how this financial loss applies to your tax return, and how you can reap whatever tax benefits possible and get your business on a better financial track for next year. Call now to schedule a consultation.