If you’re a sole proprietor, it’s likely that your greatest fear is that your business will lose money. Unfortunately, this is an all too common occurrence. Your business can lose money in a tax year for many reasons, including a bad economy, increased competition, or theft or casualty losses.
But the dark cloud of business losses has a silver lining: The Internal Revenue Service (IRS) allows you to deduct your losses against your income for federal tax purposes. You might even be able to deduct your losses from your state taxes, but the rules for this vary from state to state.
What Is a Net Operating Loss?
Your sole proprietor business has a loss for the year if all your deductible expenses listed in your Schedule C exceed your business income. The first thing to do is deduct this loss from any other income you may have. This includes your spouse’s income as well if you file jointly.
If your losses exceed your income from all sources for the year, you have a “net operating loss” (NOL). How to deduct an NOL depends on the year it was incurred. The rules have repeatedly changed over the past few years.
NOLs for 2017 and Earlier
For NOLs occurring during 2017 and earlier, business owners could “carry a loss back”—that is, they could apply an NOL to past tax years by filing an application for a 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, and then carried forward 20 years. Moreover, NOLs could reduce taxable income to zero in the carryback or carry forward years. You also had the option to elect to only carry an NOL forward to future years.
NOLs for 2018 through 2020
The Tax Cuts and Jobs Act (TCJA) radically changed NOL deductions starting in 2018. However, Congress temporarily changed these rules in reaction to the COVID-19 pandemic.
The TCJA eliminated all carrybacks of NOLs starting in 2018. Instead, taxpayers were only allowed to deduct them in any number of future years. Moreover, an NOL could only offset up to 80% of taxable income (before the pass-through deduction) for any year.
Due to the economic devastation caused by the coronavirus pandemic, Congress amended the rules for 2018 through 2020 to make it easier to deduct NOLs. For these years, an NOL may be carried back five years and then carried forward indefinitely until used up. Ordinarily, you must carry an NOL back to the earliest year within the carryback period in which there is taxable income, then to the next earliest year, and so on. Also, NOLs for these years may offset 100% of taxable income to reduce the tax liability to zero.
You didn’t have to carry back an NOL for 2018 through 2020 for five years if you didn’t want to. You could elect to apply the NOL only to future years by attaching a statement to your tax return for the year. For 2018 and 2019 NOLs, you had to make this election on your 2020 tax return.
NOLs for 2021 and Later
The NOL rules initially put in place in 2018 by the TCJA, and then postponed for 2018-2020, return for 2021, and later. So, for 2021 and later years you may only deduct NOLs for the current year and any number of future years. You may not carry them back to deduct in past years. In addition, NOLs for these years may only offset up to 80% of taxable income (before the pass-through deduction) for any year.
Excess Business Losses
Yet another limit applies to deducting NOLs. The TCJA limited deductions of “excess business losses” by individual business owners during 2018 through 2025. Married taxpayers filing jointly could deduct no more than $519,000 per year in total business losses. Individual taxpayers could deduct no more than $259,000. Unused losses had to be deducted in any number of future years as part of the taxpayer’s NOL carryforward. Congress eliminated this dollar limitation for losses incurred during 2018 through 2020. So, taxpayers with very large losses for any of these years could deduct them in full.
The excess business loss limit returned for 2021 and was extended through 2026. For 2021, NOLs were limited to $262,000 for individual taxpayers and $524,000 for married taxpayers filing jointly. Losses over these amounts must be carried forward and deducted in future years.
Calculating an NOL
Calculating a net operating loss can be complicated, and you might need the help of an accountant. It's not as simple as deducting your losses from your annual income. Instead, you calculate your adjusted gross income for the year (which should be a negative number due to your losses) and then add back to it certain nonbusiness deductions to determine your NOL. These include the standard deduction or itemized deductions, nonbusiness capital losses, IRA contributions, and charitable contributions. The resulting number is your net operating loss from business. You can use Schedule A of IRS Form 1045, Application for Tentative Refund, to calculate your NOL.
A Tax Lawyer Can Help
The law surrounding net operating losses is complicated. Plus, the facts of each case are unique. This article provides a brief, general introduction to the topic. For more detailed, specific information, contact a tax lawyer.