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If you're like most small business owners, you won't see a profit in your first year of operation. And as your business grows, you may face one or more years in which your business's expenses exceed its income. You may also make tax planning decisions, such as claiming bonus depreciation or expensing assets, that create a loss for tax purposes. In other words, the business may have a loss for the year.
Although it may be small comfort, if you have a loss and your business is organized as a sole proprietorship, you'll normally be able to deduct the loss from your total income from other business ventures or from any salary, wages, or other earnings. If the business loss exceeds your total income for the year, any unused portion of the loss, which is known in the tax laws as a net operating loss (NOL), can be used to offset income and reduce taxes in other years.
The net operating loss deduction is an exception to the general income tax rule that your taxable income is determined on the basis of your current year's events. This deduction allows you to offset one year's losses against another year's income. A net loss from the operation of a trade or business, casualty losses, and losses resulting from employee business expenses are included in this computation, but losses from a trade or business are the most common occurrence.
Calculating an NOL can be tricky and we suggest that, if you have one, you consult a professional to help ensure you do it correctly, or get the IRS's free Publication 536, Net Operating Losses. The following discussion is intended to give you a basic understanding of how NOLs work for sole proprietors:
Other forms of business. If your business is organized as a partnership, a multiple-owner LLC (which is treated as a partnership), or an S corporation, different, even more complicated rules apply.
Generally, a partner's share of the partnership loss (including capital loss) is allowed only to the extent of the adjusted basis of his or her partnership interest at the end of the partnership's tax year in which the loss occurred (but before reduction by the current year's loss). This is not necessarily the same as the balance in the partner's capital account. Any excess is allowed as a deduction in later years to the extent that the partner's basis is increased above zero.
The rules for S corporation shareholders are similar, with one major exception. A shareholder of an S corporation only increases his or her basis in the shares by any loans made directly from the shareholder to the corporation. Indebtedness guaranteed by a shareholder does not increase basis. Thus, a shareholder's basis in his or her interest will be less, in most cases, than a partner's.
The partner's or shareholder's allowable loss may be deducted by the partner on his or her individual returns as a business loss, subject to the passive activity rules. Although the partnership itself may not carry the loss backward or forward to other years as a net operating loss, the partners' shares of the loss may result in net operating loss carrybacks or carryovers on their individual returns. For more information on how this would work, consult your tax advisor.
If your business is organized as a C corporation, any net operating loss it suffers provides no tax benefit to the shareholders. Such a loss can only be used by the corporation itself; it may be offset against the income of its subsidiaries (if any) if a consolidated return is filed, carried back against past income, or carried forward to reduce future income. A corporation can carry a net operating loss back two years and forward 20 years. If net operating losses are anticipated by a corporation, it may be beneficial to elect S corporation status and pass the losses on to the shareholders.