Business Loss Deduction: What Is It and How Does It Work?

When a business’s deductible expenses for a tax year are greater than its income, it results in a business loss. This loss can be used as a deduction to lower the taxpayer’s overall taxable income from other sources, such as wages or investment income.

Determining Your Business’s Net Profit or Loss

To determine if you have a business loss, you must calculate your business’s net profit or loss for the tax year. The formula is Gross Income minus Deductible Expenses equals Net Profit or Loss. If the result is negative, your business has incurred a net loss.

Gross income is all the revenue your business generated. For businesses that sell goods, you must first calculate the cost of goods sold (COGS), which includes the direct costs of producing the items sold. Gross income is then determined by subtracting COGS from total sales revenue.

Next, you must total all your deductible business expenses. For an expense to be deductible, the IRS requires it to be both “ordinary and necessary” for your trade or business. An ordinary expense is common in your industry, while a necessary expense is helpful and appropriate for your business.

Common deductible expenses include:

• Salaries and wages paid to employees
• Rent or mortgage interest for your office or facility
• Utilities like electricity, water, and internet
• Office supplies, marketing, and advertising costs
• Business-related travel expenses
• Insurance premiums for liability or property coverage
• Professional fees paid to accountants or lawyers
• Vehicle expenses and the cost of repairs to business property

Limitations on Deducting Business Losses

Several tax rules can limit the amount of a business loss you can deduct from other income. These limitations are designed to prevent taxpayers from using certain losses to unfairly reduce their tax liability.

The Hobby Loss Rule

The IRS distinguishes between a business operated for profit and a hobby pursued for personal enjoyment. If an activity is classified as a hobby, you cannot deduct its losses to offset other income. Internal Revenue Code Section 183 provides guidelines to determine if an activity is engaged in for profit.

The IRS considers factors like whether you conduct the activity in a businesslike manner, the time and effort you invest, your expertise, and your history of income or losses. An activity is presumed to be for profit if it has been profitable in at least three of the last five tax years.

At-Risk Limitations

The at-risk rules prevent taxpayers from deducting losses that exceed the amount of money they personally have at stake in the business. Your at-risk amount includes cash you contributed, the adjusted basis of property you contributed, and certain amounts you borrowed for which you are personally liable.

For example, if you invest $10,000 of your own money and the business incurs a $15,000 loss, your deduction would be limited to your $10,000 at-risk amount. The remaining $5,000 loss is suspended and can be carried forward. You can deduct that suspended loss in a later year if your at-risk amount increases.

Passive Activity Loss (PAL) Rules

A passive activity is a trade or business in which the taxpayer does not “materially participate.” Rental activities are typically considered passive by default. The passive activity loss (PAL) rules state that losses from passive activities can only be used to offset income from other passive activities.

To avoid this limitation, you must demonstrate material participation. The most common test is participating in the activity for more than 500 hours during the tax year. If you meet one of the IRS tests, the activity is not considered passive. Unused passive losses are suspended and carried forward to offset future passive income or are fully deductible when you dispose of the activity.

Excess Business Loss (EBL) Limitation

The excess business loss (EBL) rule applies to non-corporate taxpayers and places a dollar cap on the total net business losses you can deduct in a single year. For tax year 2024, the limit is $305,000 for single filers and $610,000 for married couples filing jointly. For 2025, these amounts increase to $313,000 and $626,000, respectively.

This limitation is applied after the at-risk and passive activity loss rules. If your total net losses from all businesses exceed the annual threshold, the excess amount is disallowed for the current year. This disallowed portion is treated as a net operating loss (NOL) carryforward to subsequent tax years.

Understanding Net Operating Losses (NOLs)

When an allowable business loss is greater than your other income for the year, it creates a Net Operating Loss (NOL). The NOL amount may not be the same as the net loss on your business’s profit and loss statement, as certain adjustments for non-business items may be required.

For most businesses, NOLs arising in tax years after 2020 cannot be carried back to prior tax years, with limited exceptions for certain farming businesses. These NOLs can only be carried forward indefinitely to offset income in future years.

There is a restriction on the use of NOL carryforwards. The deduction for an NOL generated after 2017 is limited to 80% of the taxable income in the future year to which it is carried. This means an NOL can significantly reduce future tax liability but may not eliminate it in a given year.

For example, if you have a $50,000 NOL and $40,000 of taxable income the next year, your deduction is limited to $32,000 (80% of $40,000). This would leave you with $8,000 of taxable income. The unused $18,000 of your NOL ($50,000 – $32,000) can be carried forward to subsequent years.

Reporting Business Losses on Your Tax Return

Reporting a business loss involves a sequence of IRS forms to calculate the loss and apply any limitations. The process starts on the form where you calculate your business’s profit or loss, which for sole proprietors is Schedule C (Form 1040). A loss on this form is the starting point for the limitation tests.

Next, you must work through the forms associated with the loss limitations.

• Form 6198, At-Risk Limitations, is used to determine if your deductible loss is restricted by the amount you have personally at stake.
• Form 8582, Passive Activity Loss Limitations, is used if your business is a passive activity to calculate how much loss can be deducted against passive income.
• Form 461, Limitation on Business Losses, is used to determine if your total net business losses exceed the annual threshold.

The final, allowable loss amount is then transferred to Schedule 1 of your Form 1040, where it reduces your total adjusted gross income.

Any portion of a loss disallowed by these limitations is carried forward. Losses limited by the at-risk or passive activity rules can be used in future years when you have a sufficient at-risk basis or passive income. A loss disallowed by the excess business loss rule is treated as an NOL and is carried forward, subject to the 80% taxable income limitation.