How Much of a Business Loss Can I Deduct?
When losses from all your business and investment activities are more than your overall income, you have a “net operating loss” (NOL) that can be applied to your income from non-business sources like paid employment, for example. NOL can also be used to reduce your tax liability not only for future years (carryovers) but for years that have passed (carrybacks).
A carryback can be a real lifesaver for a business since it provides an injection of capital through a tax refund. You may waive carrybacks, and doing so allows you to apply an NOL to future years until it is fully absorbed — a good strategy if you think you’re going to be in higher tax brackets.
How much of your business loss will translate into a NOL depends on a number of factors, including your business capital losses and gains and your nonbusiness income and deductions.
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How to Calculate Business Losses
Calculating your business losses is the first step to lowering your tax bill. You also have to figure out how those losses might be applied to give you the minimum tax liability. That means working out how much of your business loss is a Net Operating Loss (NOL) under IRS rules.
Here’s how you might do that in four easy steps:
- Determine your total income by adding the amounts from all sources
- Determine total deductions either by adding all itemized deductions or simply taking the standard deduction
- Subtract the total deductions figure by non-allowable items
- Determine your NOL by subtracting the adjusted deductions figure from your total income
Non-allowable items include capital losses in excess of capital gains and nonbusiness deductions in excess of nonbusiness income.
We’ve included a simple example below to show you how that works.
Calculating Net Operating Loss
Here’s an example that illustrates how to calculate a NOL:
Jill operates a water-carrying business, which has begun to run up losses. Luckily, she also has a regular day job. She has also made some money by selling off part of the farm and from interest on a fixed deposit.
Here’s what her income for 2019 looks like:
|Salary from day job||$7,200|
|Interest on Certificate of Deposit||$1,000|
|Capital gain on selling farmland||$3,500|
|Jill’s Total Income||$11,700|
And her deductions:
|Net loss from business||$8,975|
|Capital loss on sale of securities held for less than a year||$1,500|
|Standard deduction for 2019||$12,200|
|Jill’s Total Deductions||$22,675|
Jill has a loss of $11,700 - $22,675 = -$10,975.
However, this is not the same thing as NOL. Not all deductions that go into calculating a business loss are allowed when calculating NOL. Some of Jill’s deductions won’t be allowed.
Jill’s Non-Allowable Items:
|Non-business short term capital loss: sale of securities||$1500|
|Less non-business income: interest on CD||$1,000||$11,200|
Now Jill can calculate her NOL:
|Jill’s total income||$7,200|
|Subtract: Non-Allowable Items||$12,700||$9,975|
Jill’s Net Operating Loss (NOL) for 2019 is $2,775.
How to Claim a Business Loss
The CARES Act expanded the options for using NOLs for the 2018, 2019, and 2020 tax years. Businesses will once again be allowed to carry back NOLs, for five years now instead of the previous limit to two years. Additionally, the limit on NOL carryovers is suspended for the 2018, 2019, and 2020 tax years. Formerly, only 80% of NOL could be used against taxable income in the NOL year. The 20% balance had to be carried forward.
Also, owners of pass-through business entities may use NOLs to offset their non-business income above the previous limit of $250,000 (single) or $500,000 (married filing jointly) for 2018, 2019, and 2020.
You can claim a business loss by using your NOL to reduce taxable income in both past and future years. Under the current rules, here’s how Jack may apportion an NOL of $50,000 his business incurred in 2019.
|Balance of Loss
If you choose to carry back your NOL, the entire balance must be carried back to the fifth tax year before the NOL year. Any loss not used in the fifth year preceding the loss is then carried forward to the next year and so on until the NOL is exhausted.
Types of Tax-Deductible Business Expenses
The IRS says that for a business expense to be deductible, it must be both “ordinary and necessary.” This means it must be the sort of expense that is common and appropriate to your kind of business. For retailers, the cost of goods sold would be a typical and appropriate expense. In general, small businesses are likely to incur expenses for rent, wages and salaries, insurance, depreciation, business-related meals, travel, training, and utilities.
To learn more, check out our article on tax-deductable business expenses.
How Do Losses Affect Different Types of Businesses
All businesses that have “pass-through entity” tax status — sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations — may apply losses to their owners’ NOL. However, C corporations cannot.
What are Excess Business Losses?
Excess business losses are net business losses incurred by a taxpayer that are greater than certain limits imposed by the Tax Cuts and Jobs Act (TCJA).
Net business losses are business income minus business deductions. For 2019, the limits were $255,000 for a single taxpayer (or $520,000 if married and filing jointly). Those are the amount of business losses that can be used in the loss year to reduce non-business taxable income. Any loss above these thresholds are excess business losses (EBL) and can be carried forward as a net operating loss (NOL) to provide tax relief in future years.
However, the CARES Act has suspended these limits until January 1, 2021. This means that you will be able to fully deduct business losses arising in 2018, 2019, and 2020. Here’s an example to make this more clear.
In 2019, Tom received non-business income (interest and dividends) of $400,000 as well as business income of $125,000 through an S corporation. However, he suffered a loss of $450,000 in a partnership.
Under the TCJA Rules
|S Corporation Income||$125,000|
|Loss from partnership||$(450,000)|
|Excess Business Loss Limit||$255,000|
|Excess Business Loss||$(70,000)|
|Interest & Dividends||$400,000|
|Excess Business Loss Limit||$255,000|
|Taxable Income for Current Year||$145,000|
Tom’s net business losses (business income minus business deductions) are $325,000. He can only use $255,000, so his taxable income for 2019 would have been $400,000 - $255,000 = $145,000.
After Suspension of TCJA Rules
The CARES Act has amended the tax code, and Tom can apply the full $325,000 of business losses to his non-business income of $400,000, thereby reducing his taxable income to $75,000. This is good news for many small business owners hard hit by the pandemic. If they have filed returns for 2018 and 2019, they can file amended returns or apply directly for a refund.
Business Loss Deductions Frequently Asked Questions
Can you write off a business loss on your taxes?
Yes. You can write off your business losses against non-business income.
How much business loss can you write off?
For the 2018, 2019, and 2020 tax years, you can write off all your business losses.
How do I claim a Net Operating Loss (NOL)?
You can take advantage of an NOL either by either filing Form 1045 for a tentative refund or by filing an amended tax return on Form 1040X for the carryback year.
What are the benefits of filing Form 1045?
You are likely to receive a refund much quicker than if you file an amended return. The IRS must process an application for tentative refund (Form 1045) within 90 days.
Is there a time limit on filing an amended return to claim an NOL carryback?
Yes. There is a time limit of three years from the due date, including extensions. If you had an NOL in 2019, your amended return should be filed no later than October 15, 2023.
Can a business loss offset other income?
Yes. A business loss can offset income from other sources, such as paid employment.
Can I deduct losses from my LLC?
Yes, if you alone own the LLC, you can file as a “disregarded entity” and take all the losses. If you own the LLC together with others, you can use your share of the loss.