What Is California Form 3805Q and Who Needs to File It?

Businesses and individuals in California may experience financial losses that exceed their income for a given year. To account for these losses, the state allows taxpayers to report and carry forward net operating losses (NOLs) using Form 3805Q. Properly filing this form helps eligible taxpayers reduce taxable income in future years.

Who Must Complete the Form

Taxpayers who incur an NOL in California and wish to claim a deduction in the current or future tax years must file Form 3805Q. This applies to individuals and businesses, including sole proprietors, partnerships, and corporations, that generate income subject to California tax.

Corporations, both domestic and foreign, must complete this form if they report an NOL on their state tax return. This includes C corporations and S corporations with losses exceeding taxable income. While S corporations do not directly benefit from NOL deductions, shareholders may claim a portion of the loss on their personal tax returns, depending on their ownership percentage and basis in the company.

Self-employed individuals and sole proprietors reporting business income on Schedule C must file Form 3805Q if their business expenses exceed revenue. Partnerships and LLCs taxed as partnerships must also complete the form to document NOLs, though the actual deduction is passed through to individual partners or members.

Calculating the Net Operating Loss

Determining an NOL for California tax purposes involves more than subtracting expenses from income. The state has specific rules for allocating and apportioning losses, particularly for taxpayers with income from multiple sources or those operating in multiple states. Certain deductions also impact the final NOL calculation.

Business and Nonbusiness Allocations

California distinguishes between business and nonbusiness income when calculating an NOL. Business income comes from activities conducted within the state, such as revenue from a California-based company or self-employment earnings. Nonbusiness income includes passive sources like dividends, interest, and rental income from properties outside California.

Only business-related losses contribute to an NOL deduction. Nonbusiness losses, such as capital losses from stock sales, are generally limited to offsetting nonbusiness income. If a taxpayer has both types of income, they must allocate losses accordingly under California’s allocation rules.

For example, if a taxpayer earns $100,000 in business income from a California-based LLC but incurs $150,000 in business expenses, they may have a $50,000 NOL. However, if they also receive $20,000 in dividend income from out-of-state investments, that income does not affect the NOL calculation.

Apportioning Losses from Multiple Sources

Taxpayers operating in multiple states must apportion their losses based on California’s tax apportionment rules. The state follows a single-sales factor formula, meaning the percentage of total sales occurring in California determines the portion of income and losses allocated to the state.

For instance, if a corporation has $1 million in total sales, with $400,000 generated in California, 40% of its income and losses are attributed to the state. If the company reports a $200,000 NOL, only $80,000 is recognized as a California NOL.

This method prevents businesses with operations in multiple states from applying out-of-state losses to reduce their California tax liability.

Deductions That Affect NOL

Certain deductions can reduce or eliminate an NOL. California does not allow personal exemptions when calculating an NOL. Additionally, state and local tax deductions, charitable contributions, and capital loss limitations must be considered.

Depreciation deductions under the Modified Accelerated Cost Recovery System (MACRS) can also impact NOL calculations. If a business claims significant depreciation expenses, it may increase the reported loss. However, California does not conform to all federal depreciation rules, meaning adjustments may be necessary.

The state also disallows certain federal deductions, such as the Qualified Business Income (QBI) deduction under Internal Revenue Code Section 199A. While this deduction reduces taxable income at the federal level, it does not apply to California taxes, potentially altering the NOL calculation.

Adjustments for Pass-Through Entities

Pass-through entities, such as partnerships, S corporations, and LLCs taxed as partnerships, do not pay income tax at the entity level. Instead, the loss is distributed to individual partners, members, or shareholders based on their ownership percentage. California requires these entities to calculate and report NOLs at the entity level before passing them through to the owners.

Partners or members can only deduct their share of the NOL to the extent they have sufficient tax basis in the entity. If a partner’s basis is insufficient, the unused portion of the NOL is suspended until the basis increases, such as through additional capital contributions or allocated income in future years. At-risk rules further restrict loss deductions to the amount an individual has at risk in the business, including cash investments and personally guaranteed loans.

For S corporation shareholders, California follows federal passive activity loss (PAL) rules, which limit the ability to deduct losses from passive business activities. If a shareholder does not materially participate in the S corporation’s operations, their share of the NOL may be subject to passive loss limitations, meaning it can only offset passive income.

California also conforms to federal excess business loss (EBL) limitations, which cap the amount of business losses that non-corporate taxpayers can deduct against non-business income. Any excess loss is converted into an NOL carryforward for use in future years.

Part-Year and Nonresident Filers

Taxpayers who reside in California for part of the year or earn income from the state while living elsewhere must track which business activities, investments, or self-employment earnings are attributable to California.

For individuals who move into or out of the state mid-year, the NOL calculation must reflect the period of residency. If a taxpayer operates a sole proprietorship and incurs a $70,000 loss while living in California for six months, the deductible portion depends on the percentage of business activity sourced to the state. If 80% of revenue-generating operations occurred in California, then $56,000 of the loss may be eligible for NOL treatment on the state return.

Nonresidents with California-source income, such as rental property owners or remote workers with an in-state employer, must apply similar principles. If a nonresident’s California business generates a $100,000 loss but only 60% of total sales occur in the state, just $60,000 qualifies as a California NOL.

Carryforward Treatment

California allows taxpayers to carry forward NOLs to offset future taxable income but does not permit NOL carrybacks. Losses cannot be applied to prior years to claim a refund on previously paid taxes.

The state generally permits a 20-year carryforward period, aligning with federal rules. However, California has imposed temporary suspensions on NOL deductions in certain years due to budgetary concerns.

Taxpayers must track their NOL carryforwards carefully, as California requires detailed recordkeeping to substantiate deductions in future years. Form 3805Q must be filed annually to report remaining NOL balances.

Filing Requirements and Documentation

Form 3805Q must be attached to the California tax return for any year in which an NOL is generated or utilized. Taxpayers should maintain supporting documentation, including income statements, expense records, and prior-year tax returns.

The Franchise Tax Board (FTB) may request additional documentation during an audit, so maintaining organized records is essential.