How to Use LLC Losses to Offset W2 Income

It is possible to use losses from a Limited Liability Company (LLC) to reduce W2 wage income, but this ability is subject to tax rules. These rules ensure that business loss deductions are taken by taxpayers genuinely involved in the activity or who have a true financial stake. The IRS implements limitations to prevent individuals from deducting losses from ventures where their involvement is minimal or their financial risk is not substantial.

Understanding Passive and Non-Passive Activities

A foundational concept for business losses is the distinction between passive and non-passive activities. A passive activity refers to any trade or business in which the taxpayer does not materially participate. Losses from passive activities can only offset income generated from other passive activities. This means such losses cannot directly reduce active income sources, like W2 wages, or portfolio income.

In contrast, a non-passive activity is one where the taxpayer materially participates. Losses from non-passive activities are deductible against any type of income, including W2 wages, provided other limitations are met. Most rental activities are automatically considered passive by the IRS, but qualified real estate professionals may treat them as non-passive if they meet specific criteria. The classification of an LLC’s activity as passive or non-passive is the initial step in determining if its losses can be used to offset W2 income.

Applying At-Risk Limitations

Separate from passive activity rules, the “at-risk” limitations impose another layer of deductibility constraints on losses. These rules limit the amount of loss a taxpayer can deduct from an activity to the amount they are considered “at risk” in that activity. An individual’s at-risk amount includes money and the adjusted basis of property contributed to the activity, along with certain borrowed amounts for which they are personally liable. Non-recourse debt, where the borrower is not personally liable and the debt is secured only by the activity’s property, does not increase the at-risk amount.

The at-risk amount is calculated annually and can increase with additional contributions or income from the activity, and decrease with losses or distributions. Any losses disallowed due to these limitations are suspended and carried forward indefinitely. These suspended losses can be deducted in a future tax year when the taxpayer’s at-risk amount in the activity increases. Both the at-risk rules and passive activity rules must be satisfied for a loss to be deductible.

Meeting Material Participation Requirements

Material participation is a central concept in classifying an activity as non-passive, which is important for an LLC owner seeking to deduct losses against W2 income. If an LLC owner materially participates in the business, the activity is considered non-passive, meaning its losses are not subject to the passive activity loss limitations. The IRS provides seven specific tests to determine if an individual materially participates in an activity. Meeting just one of these tests is sufficient to establish material participation.

Material Participation Tests

Participating in the activity for more than 500 hours during the tax year.
Involvement constitutes substantially all of the participation in the activity by all individuals, including non-owners.
Participating for more than 100 hours during the tax year, and no other individual participates for more hours.
Participating in one or more trade or business activities for more than 100 hours each, with aggregate participation exceeding 500 hours (significant participation activities).
Material participation in the activity for any five of the preceding ten tax years.
Material participation for any three preceding tax years if the activity is a personal service activity. A personal service activity involves fields like health, law, accounting, or consulting where capital is not a material income-producing factor.
Participating on a regular, continuous, and substantial basis for more than 100 hours, and no other person, including a paid manager, manages the activity for more hours (facts and circumstances).

Maintaining detailed records, such as time logs, is important to substantiate material participation.

Other Loss Limitations and Carryovers

Beyond the at-risk and passive activity rules, non-corporate taxpayers may face an “excess business loss limitation.” This rule caps the amount of business losses that can be deducted in a single tax year against non-business income. For tax years beginning after 2020 and before 2029, if total business deductions exceed total business gross income and gains by more than a specified threshold (which is adjusted annually for inflation), the excess is disallowed for the current year. For instance, in 2024, this threshold was $305,000 for single filers and $610,000 for those filing jointly. This limitation applies after the at-risk and passive activity rules have been considered.

Any losses disallowed due to the excess business loss limitation are treated as a net operating loss (NOL) carryover to the following tax year. This means the disallowed losses can be used to offset income in future years, subject to the NOL rules in effect for those years. If a loss is disallowed in a current year due to passive activity rules, at-risk rules, or the excess business loss limitation, it is carried forward to subsequent years. These carried-forward losses can then be deducted when the specific limitation is overcome, such as when passive income is generated, the at-risk amount increases, or the excess business loss threshold is not exceeded.

Reporting LLC Losses on Your Tax Return

The method for reporting LLC losses on a tax return depends on how the LLC is classified for tax purposes. If the LLC is a single-member LLC not electing to be taxed as a corporation, it is treated as a sole proprietorship. Income and losses are reported on Schedule C (Form 1040), Profit or Loss from Business. A loss reported on Schedule C can offset other income on the individual’s personal tax return, subject to the various limitations discussed.

For LLCs with multiple members, they are treated as partnerships for tax purposes, unless an election is made to be taxed as a corporation. A partnership LLC files Form 1065, U.S. Return of Partnership Income, and each member receives a Schedule K-1 (Form 1065) detailing their share of the LLC’s income or loss. If an LLC elects to be taxed as an S corporation, it files Form 1120-S, U.S. Income Tax Return for an S Corporation, and members receive Schedule K-1 (Form 1120-S). The losses from these flow-through entities are then reported on the individual owner’s personal tax return, on Schedule E (Form 1040), Supplemental Income and Loss.

When passive activity losses are incurred, Form 8582, Passive Activity Loss Limitations, is used to calculate and apply these limitations. This form ensures that passive losses only offset passive income. For at-risk limitations, Form 6198, At-Risk Limitations, is used to determine the deductible amount of loss based on the taxpayer’s economic investment. Accurate record-keeping is important for substantiating all income, expenses, and participation levels, and consulting a tax professional is often advisable.