How to Claim a Loss on Business Taxes

When a business incurs more expenses than it generates in revenue over a specific period, the result is a business loss for tax purposes. A business loss can offer significant tax advantages by potentially reducing an owner’s overall taxable income. Claiming these losses on a tax return allows business owners to offset income from other sources, such as wages or investments, thereby lowering their total tax liability. This provides relief, particularly for new or struggling businesses that may experience initial periods of unprofitability. Understanding how to identify, calculate, and report these losses is an important aspect of tax planning for entrepreneurs.

Identifying Deductible Business Losses

A business loss arises when deductible expenses exceed the income generated by a trade or business. A common type is a net operating loss (NOL), which occurs when a business’s allowable tax deductions surpass its taxable income for a given year. NOLs are particularly relevant for businesses in their early stages or those facing economic downturns.

Businesses may also experience deductible losses from specific events. Casualty and theft losses related to business property can be claimed if the property is damaged or stolen due to a sudden, unexpected, or unusual event. The amount of the loss is reduced by any insurance or other reimbursements. These losses must be directly attributable to the business’s operations.

Bad business debts represent another category of deductible losses. A debt is considered “bad” when there is no reasonable expectation of collection. For a debt to be deductible as a business bad debt, it must have arisen from the ordinary course of the taxpayer’s trade or business. For instance, an accrual basis taxpayer might incur a bad debt if they record income for services rendered but cannot collect payment.

Calculating and Substantiating Business Losses

Calculating a business loss begins with meticulous bookkeeping. Accurate records of all income and expenses are fundamental for determining if a business has operated at a deficit.

The accounting method employed by a business also influences loss calculation. Under the cash method, income is recognized when received and expenses are deducted when paid. The accrual method recognizes income when earned and expenses when incurred, regardless of when cash changes hands. The chosen method must be applied consistently to accurately reflect the business’s financial position.

Substantiating the calculated loss requires thorough documentation. This includes income statements, balance sheets, and general ledgers. Specific documentation for expenses, such as receipts, invoices, bank statements, and canceled checks, is important to support all deductions claimed. For casualty and theft losses, police reports, insurance claims, and appraisals are necessary. For bad debts, evidence of the debt’s existence, efforts to collect, and its worthlessness must be retained. These records are necessary for justifying the loss amount to tax authorities.

Understanding Limitations on Loss Deductions

While business losses can reduce taxable income, various rules limit the amount and timing of deductions. Net Operating Losses (NOLs) occur when a business’s deductions exceed its gross income. For tax years beginning after 2017, NOLs cannot be carried back to prior years, but they can be carried forward indefinitely. The amount of an NOL deduction used in any future year is limited to 80% of taxable income, computed without regard to the NOL deduction itself. This means an NOL cannot reduce taxable income to zero in a future year.

Passive Activity Loss (PAL) rules restrict the deduction of losses from passive activities, which are generally trades or businesses in which the taxpayer does not materially participate. Losses from passive activities can only offset income from other passive activities. If passive losses exceed passive income, the excess loss is suspended and carried forward indefinitely to offset passive income in future years. Special allowances exist for rental real estate activities, permitting certain taxpayers to deduct up to $25,000 of passive losses against non-passive income, subject to adjusted gross income (AGI) phase-out rules.

The At-Risk Rules limit loss deductions to the amount a taxpayer has personally invested in an activity and is therefore “at risk” of losing. This includes cash contributions, the adjusted basis of property contributed, and amounts borrowed for which the taxpayer is personally liable or has pledged property as security. Losses exceeding the at-risk amount are suspended and can be carried forward to future years if the taxpayer’s at-risk amount increases. These rules apply before the PAL rules are considered.

Excess Business Loss (EBL) limitations apply to noncorporate taxpayers. An EBL is the amount by which total deductions attributable to all trades or businesses exceed the total gross income and gains from those businesses plus a threshold amount. For 2025, this threshold is adjusted for inflation (e.g., $300,000 for single filers and $600,000 for married filing jointly). Any excess business loss is disallowed in the current year and is treated as an NOL carryforward to the next taxable year.

The Hobby Loss rules prevent taxpayers from deducting losses from activities not engaged in for profit. The IRS presumes an activity is engaged in for profit if it shows a profit in at least three out of five consecutive tax years (or two out of seven years for horse breeding, training, or racing). If an activity is deemed a hobby, deductions are limited to the amount of income generated by the activity. The IRS examines factors such as the manner in which the taxpayer carries on the activity, their expertise, time and effort expended, and the expectation of asset appreciation to determine if a profit motive exists.

Reporting Business Losses on Your Tax Return

The method for reporting a business loss on a tax return depends on the business’s legal structure. Sole proprietors report their business income and expenses, including any loss, on Schedule C (Profit or Loss from Business) of Form 1040. The net loss calculated on Schedule C then flows directly to Schedule 1 of Form 1040, where it reduces the taxpayer’s adjusted gross income.

Partnerships and multi-member LLCs filing as partnerships use Form 1065 (U.S. Return of Partnership Income) to report their financial results. Any business loss is passed through to the individual partners or members based on their ownership percentages. Each partner receives a Schedule K-1, and the loss is then reported on Schedule E (Supplemental Income and Loss) of the individual’s Form 1040.

S corporations file Form 1120-S (U.S. Income Tax Return for an S Corporation) and pass losses through to their shareholders. Shareholders receive a Schedule K-1 detailing their share of the loss, which they then report on Schedule E of their Form 1040. C corporations, which are separate legal and tax entities, report their losses on Form 1120 (U.S. Corporation Income Tax Return). These losses do not pass through to the owners’ personal tax returns but can be used to offset corporate income in other tax years.

When limitations such as the passive activity loss rules, at-risk rules, or excess business loss limitations apply, additional forms are required. Form 8582 (Passive Activity Loss Limitations) is used to calculate the deductible amount of passive losses. Form 6198 (At-Risk Limitations) determines the amount of loss deductible based on the taxpayer’s investment at risk. If an excess business loss is incurred, Form 461 (Limitation on Business Losses) is used to calculate the disallowed amount, which then becomes an NOL carryforward. These forms ensure all applicable rules are considered before the final deductible loss amount impacts the individual’s tax liability on Form 1040.