Can You Write Off Business Losses on Your Taxes?

When a business’s expenses exceed its income, it results in a business loss, which can reduce a taxpayer’s overall tax liability. The Internal Revenue Service (IRS) provides specific rules and limitations for deducting these losses. Understanding these provisions helps business owners and individuals accurately report financial outcomes and maximize tax benefits.

Defining a Business Loss

For tax purposes, a business loss occurs when the total allowable business expenses exceed the total business income for a given tax period. The IRS distinguishes between activities engaged in for profit, which qualify as a business, and those primarily for personal enjoyment, considered a hobby. This distinction is important because only legitimate businesses can deduct losses against other income.

An activity qualifies as a business if the primary purpose is to generate income or profit, and the taxpayer is involved with continuity and regularity. Business expenses must be both “ordinary and necessary” for the industry in which the business operates. An ordinary expense is common and accepted in the trade, while a necessary expense is helpful and appropriate for business operations. Examples of deductible business expenses include operating costs, employee wages, rent, utilities, insurance, marketing, and depreciation on business assets. Non-deductible personal expenses, such as commuting costs or personal entertainment, cannot contribute to a business loss.

Understanding Loss Limitations

Tax law includes several provisions that limit the amount of business loss a taxpayer can deduct in a given year. These limitations ensure deductions are tied to genuine economic risk and profit motive.

Hobby Loss Rules

The “hobby loss” rules, found in IRC Section 183, apply to activities not engaged in for profit. The IRS presumes an activity is for profit if it generates a net profit in at least three out of five consecutive tax years, or two out of seven years for activities involving horses. Factors the IRS considers include whether the taxpayer conducts the activity in a businesslike manner, the time and effort expended, the taxpayer’s expertise, and the expectation that assets used in the activity may appreciate.

At-Risk Rules

The “at-risk” rules, outlined in IRC Section 465, limit the amount of loss a taxpayer can deduct from an activity to the amount they are personally “at risk” of losing. This “at-risk” amount includes money and the adjusted basis of property contributed to the activity, as well as amounts borrowed for which the taxpayer is personally liable. The rules prevent taxpayers from deducting losses that exceed their actual economic investment, particularly those financed by nonrecourse loans where the taxpayer is not personally responsible for repayment. The at-risk amount is calculated annually and can increase with additional contributions or income from the activity, and decrease with losses and distributions.

Passive Activity Loss (PAL) Rules

Passive Activity Loss (PAL) rules, under IRC Section 469, restrict losses from passive activities. A passive activity generally includes any trade or business in which the taxpayer does not materially participate, as well as all rental activities. Material participation means involvement in the operations of the activity on a regular, continuous, and substantial basis. Losses from passive activities can only offset income from other passive activities, not active business income, wages, or portfolio income like interest and dividends. Any disallowed passive losses are carried forward indefinitely and can be used to offset passive income in future years or are fully deductible when the taxpayer disposes of their entire interest in the activity in a fully taxable transaction.

Excess Business Loss (EBL) Rules

The Excess Business Loss (EBL) rules, found in IRC Section 461, limit the amount of net business deductions non-corporate taxpayers can take in a single year. For tax years beginning after 2020 and before 2029, this rule caps the deductible business loss. For 2023, the threshold is $289,000 for single filers and $578,000 for married filing jointly, with these amounts adjusted annually for inflation. Any business loss exceeding this threshold is not deductible in the current year but is instead carried forward as a Net Operating Loss (NOL) to subsequent tax years. This limitation applies after the hobby loss, at-risk, and passive activity loss rules have been applied.

Net Operating Losses

A Net Operating Loss (NOL) occurs when a business’s allowable deductions exceed its gross income for a tax year, and this loss cannot be fully utilized in the current year. NOLs are a mechanism allowing businesses to smooth out their taxable income over time, providing relief during unprofitable periods by offsetting income from other years. The calculation of an NOL involves specific adjustments to taxable income, as the negative amount on a tax return is not always the exact NOL amount.

For NOLs arising in tax years beginning after 2017, the rules generally allow for indefinite carryforward. However, for NOLs arising in tax years beginning after 2020, the deduction is limited to 80% of taxable income in any given year to which the loss is carried. This 80% limitation applies to taxable income calculated before any NOL deduction itself.

Historically, NOLs could be carried back two years and forward 20 years. While the general carryback rule was eliminated for most NOLs arising after 2017, an exception exists for farming losses, which can still be carried back two years.

Claiming and Reporting Business Losses

Reporting business losses accurately on a tax return involves utilizing specific IRS forms to ensure proper calculation and application of various limitations. The process begins with reporting the business’s income and expenses.

Sole proprietors report their business profit or loss on Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship). Farmers use Schedule F (Form 1040), Profit or Loss From Farming, for similar reporting. For partnerships and S corporations, business income and losses flow through to the owners via Schedule K-1, and these amounts are then reported on the individual’s Form 1040.

After determining the initial business loss, any applicable limitations must be calculated and reported. Passive activity losses are calculated and reported on Form 8582, Passive Activity Loss Limitations. The deductible amount from this form is then carried to the appropriate schedule (e.g., Schedule C, E, or F). For excess business losses, non-corporate taxpayers use Form 461, Limitation on Business Losses, to determine the amount of loss that can be deducted in the current year and the amount carried forward as an NOL. The excess loss calculated on Form 461 is then reported on Schedule 1 (Form 1040).

If a Net Operating Loss (NOL) is generated, individuals, estates, and trusts can use IRS Publication 536 for guidance on figuring and using the NOL. While a carryback period is largely eliminated for current NOLs, if an NOL from a prior year is being carried forward to reduce current taxable income, it will be applied on Schedule 1 (Form 1040). If a carryback is applicable, such as for farming losses, Form 1045, Application for Tentative Refund, can be used to apply the NOL to a prior tax year and request a quick refund. Alternatively, Form 1040-X, Amended U.S. Individual Income Tax Return, can be filed for the carryback year.