If Your Business Has a Loss, Do You Still Pay Tax?

When a business experiences a loss, many taxpayers wonder about the implications for their tax obligations. A common misconception is that a business loss automatically eliminates tax liability. The tax treatment of business losses is complex, involving various rules and definitions that determine if and how a loss can reduce your overall tax burden.

Defining a Tax-Qualified Business Loss

For an activity to qualify as a business for tax purposes, it must be conducted with a genuine intent to make a profit. If the Internal Revenue Service (IRS) determines an activity is not engaged in for profit, it is considered a “hobby,” and different tax rules apply, often limiting loss deductions. The IRS uses nine factors to assess whether an activity is a business or a hobby.

The IRS considers nine factors to assess whether an activity is a business or a hobby:
How the taxpayer carries on the activity, including maintaining accurate books and records.
The expertise of the taxpayer and advisors, and time and effort devoted to the activity.
Expectation that assets may appreciate.
Success in similar activities.
History of income or losses.
Amount of occasional profits.
Financial status of the taxpayer.
Whether the activity involves personal pleasure or recreation.
No single factor is definitive; the IRS considers all facts and circumstances.

If an activity is deemed a hobby, its expenses are not deductible for tax years 2018 through 2025 due to changes introduced by the Tax Cuts and Jobs Act (TCJA). This means that while hobby income remains taxable, related expenses cannot offset it during this period. In contrast, losses from a tax-qualified business can offset other income, subject to various limitations.

How Business Losses Affect Your Personal Taxes

Business losses can impact your personal tax situation, but their deductibility is subject to several limitations. The type of business entity often dictates how losses are initially treated. For sole proprietorships, partnerships, and S corporations, losses flow through to the owners’ individual tax returns (Form 1040) and can offset other income sources like wages or investment income. In contrast, C corporation losses remain at the corporate level and do not pass through to individual shareholders.

The basis limitation applies to partners in partnerships and shareholders in S corporations. A partner’s or S corporation shareholder’s deductible loss is limited to their adjusted basis in the entity. This basis includes the capital contributed and the share of income, reduced by distributions and losses. Any losses exceeding this basis are suspended and can be carried forward indefinitely, to be deducted in future years when the taxpayer has sufficient basis.

The at-risk limitations (IRC Section 465) limit deductible losses to the amount a taxpayer has personally invested and is “at risk” of losing in the activity. This includes cash contributions, the adjusted basis of property contributed, and amounts borrowed for which the taxpayer is personally liable. Amounts protected against loss, such as through nonrecourse financing, do not increase the at-risk amount. If losses are disallowed under these rules, they are carried forward to future tax years until the taxpayer has an increased amount at risk.

The passive activity loss (PAL) rules (IRC Section 469) are another limitation. A passive activity is a trade or business in which the taxpayer does not materially participate. Losses from passive activities can only offset income from other passive activities, not active income (like wages) or portfolio income (like dividends and interest). If passive losses exceed passive income, the excess loss is suspended and carried forward to future years or until the activity is fully disposed of in a taxable transaction.

Material participation is determined by various tests. These include whether the taxpayer participates for more than 500 hours, or if their participation constitutes substantially all of the participation in the activity. Even if a taxpayer participates for more than 100 hours, it can be considered material participation if no one else participates more.

Real estate professionals have a special allowance. Certain rental real estate activities may not be treated as passive if specific criteria are met. This involves the taxpayer spending more than half of their personal services in real property trades or businesses in which they materially participate, and performing more than 750 hours of services in those activities.

Using Net Operating Losses

When a business experiences losses, these can sometimes exceed current income and other deductible amounts, leading to a Net Operating Loss (NOL). An NOL occurs when a taxpayer’s allowable business deductions surpass their gross income in a given tax year. NOLs are a mechanism to help businesses manage fluctuating income, allowing them to offset profitable years with periods of significant loss.

Calculating an NOL involves adjustments to taxable income, as certain non-business deductions might need to be added back. The Tax Cuts and Jobs Act (TCJA) of 2017 brought changes to NOL rules for losses arising in tax years beginning after December 31, 2017. Under these current rules, NOLs cannot be carried back to prior tax years. Instead, they can be carried forward indefinitely.

A limitation for NOLs generated after 2017 is that they can only offset up to 80% of taxable income in the carryforward year. This means that even with a large NOL, a business may still have some tax liability if it has taxable income. For most taxpayers, the rule of indefinite carryforward with the 80% limitation applies to NOLs arising in tax years ending after 2020.

The purpose of NOLs is to smooth out tax liabilities for businesses that have cycles of profit and loss. By carrying losses forward, businesses can reduce their taxable income in future profitable years, reflecting overall economic performance. This provision helps mitigate the financial impact of downturns and supports long-term viability.

Reporting Your Business Loss

Reporting a business loss on your tax return depends on your business structure. Sole proprietors (including single-member LLCs taxed as such) report their business income and losses on Schedule C (Form 1040). This schedule summarizes the business’s revenues and deductible expenses, with the net profit or loss then transferring to Form 1040.

For businesses structured as partnerships or S corporations, losses are reported differently. These entities file their own informational tax returns (Form 1065 for partnerships and Form 1120-S for S corporations) but do not pay income tax at the entity level. Instead, each partner or shareholder receives a Schedule K-1, which details their share of the business’s income, losses, deductions, and credits. The losses reported on Schedule K-1 then flow through to the individual’s personal tax return on Schedule E (Form 1040).

C corporations, which are taxed separately from their owners, report their income, gains, losses, deductions, and credits on Form 1120. Any losses generated by a C corporation remain within the corporation and are used to offset corporate-level income.

When it comes to Net Operating Losses (NOLs), taxpayers carry these forward to future tax years. While Form 1045 can be used by individuals, estates, or trusts to apply for a quick refund based on an NOL carryback, for most current NOLs, the amount is tracked and applied against future income, noted on Schedule 1 (Form 1040) in subsequent years.