Will I Get a Tax Refund If My Business Lost Money?

When a business experiences a financial loss, it can reduce a taxpayer’s overall income, potentially leading to a lower tax liability or a tax refund. Understanding how these losses are defined, applied, and limited by tax regulations is important for individuals seeking to manage their financial outcomes. This article explains how business losses affect your taxes and the steps involved in claiming a potential refund, providing essential information for navigating these complex tax situations effectively.

Defining a Business Loss for Tax Purposes

A business loss occurs when the ordinary and necessary expenses of operating a trade or business exceed its gross income within a tax year. Gross income includes all business revenue, while ordinary expenses are common in your industry, and necessary expenses are appropriate for your business. For instance, costs like rent, utilities, salaries, and supplies typically qualify as ordinary and necessary business expenses.

It is important to distinguish a genuine business from a hobby. The Internal Revenue Service (IRS) defines a business as an activity primarily intended to make a profit, while a hobby is for personal enjoyment. The IRS considers factors like whether the activity is conducted in a businesslike manner, if accurate records are maintained, and if significant time and effort are dedicated with a profit expectation. Maintaining accurate records, such as separate business and personal bank accounts, helps substantiate income and expenses, which is essential for accurately calculating any business loss. Correctly classifying your activity as a business is fundamental to claiming loss deductions, as hobby losses are subject to different rules.

How Business Losses Reduce Taxable Income

When a business incurs a loss, it can reduce an individual’s taxable income, potentially leading to a lower tax bill or a refund. For sole proprietorships, the net profit or loss from the business is typically reported on Schedule C (Form 1040), Profit or Loss from Business. This net amount flows directly to the individual’s Form 1040, impacting their adjusted gross income (AGI).

For pass-through entities such as partnerships, S corporations, or limited liability companies (LLCs) treated as partnerships, income, losses, deductions, and credits are “passed through” to the owners. Each owner receives a Schedule K-1, reporting their share, which they then include on their personal tax return (Form 1040). Thus, a business loss from these entities can also offset other income on the individual’s tax return.

A business loss can offset various income types, including wages from employment (W-2 income), interest income, dividends, and other forms of taxable income. By reducing overall taxable income, the individual’s tax liability decreases. If the reduction is substantial, it can result in a refund of taxes already paid through payroll withholding or estimated tax payments. This direct application of a business loss against other income is a primary mechanism for realizing a tax benefit.

Understanding Net Operating Losses (NOLs)

A net operating loss (NOL) occurs when a business’s deductible expenses exceed its gross income, and this loss is so significant that it not only eliminates current year taxable income but also leaves an excess. This excess loss can then offset taxable income in other tax years, potentially leading to a refund. The rules for NOLs are governed by Internal Revenue Code Section 172.

For NOLs arising in tax years beginning after 2020, there is generally no carryback period, meaning the loss cannot be used to amend prior tax returns for a refund, with specific exceptions. These exceptions include farming losses, which can be carried back two years, and losses of non-life insurance companies. Most non-farm businesses must carry their NOLs forward indefinitely until the loss is fully utilized. An NOL carryback, when permitted, can trigger a refund of taxes paid in the earlier year by reducing that prior year’s taxable income.

When carrying an NOL forward, the deduction is generally limited to 80% of the taxable income in the year the NOL is applied. This 80% limitation applies to NOLs incurred in tax years beginning after December 31, 2017, and carried forward to tax years after 2020. For example, if a business has a $100,000 NOL and $50,000 of taxable income in a future year, only $40,000 (80% of $50,000) of the NOL can be used. The remaining NOL balance continues to be carried forward. This carryforward mechanism allows businesses to utilize significant losses over time, even if not fully offset in the current year.

Key Limitations on Business Loss Deductions

Several rules limit the amount of a business loss an individual can deduct, impacting the potential for a tax refund. These limitations ensure that deductions align with the economic risk and profit motive of the activity. Understanding these restrictions is important for taxpayers to accurately determine their allowable loss.

Hobby Loss Rules

Internal Revenue Code Section 183 prevents deducting losses from activities not engaged in for profit. The IRS considers nine factors to determine if an activity is a business or a hobby, including the manner in which the activity is carried on, the expertise of the taxpayer, and the taxpayer’s history of income or losses from similar activities. If classified as a hobby, expense deductions are generally limited to the income generated by the activity. From 2018 through 2025, hobby expenses are not deductible at all.

Passive Activity Loss (PAL) Rules

Internal Revenue Code Section 469 generally limits losses from passive activities to the income generated by other passive activities. A passive activity is typically a trade or business in which the taxpayer does not materially participate, or any rental activity. Material participation generally means involvement in the operations of the activity on a regular, continuous, and substantial basis. Suspended passive losses can be carried forward indefinitely and used against future passive income or when the entire interest in the activity is disposed of in a fully taxable transaction. Exceptions exist for qualified real estate professionals, who may deduct rental losses against non-passive income.

At-Risk Rules

Internal Revenue Code Section 465 limits deductible loss from an activity to the amount the taxpayer is “at risk” in that activity. The amount at risk generally includes cash contributed, the adjusted basis of property contributed, and amounts borrowed for which the taxpayer is personally liable. These rules prevent deducting losses exceeding the actual economic investment. Losses disallowed by at-risk rules can be carried forward to subsequent tax years, becoming deductible when the taxpayer increases their amount at risk.

Claiming Your Tax Refund

Once a business loss or Net Operating Loss (NOL) has been determined and applied according to the applicable rules and limitations, the next step is to claim any resulting tax refund. The method for claiming the refund depends on whether the loss is being applied to the current tax year or carried back to a prior year.

If a business loss reduces your current year’s taxable income, the refund is generated when you file your annual income tax return, Form 1040. The reduced tax liability will result in a lower amount due or an increased refund if you overpaid through withholding or estimated payments.

When an NOL is carried back to a prior tax year, taxpayers have two primary options for claiming a refund: filing an amended return or using an application for tentative refund.

Amended Return (Form 1040-X)

Form 1040-X, Amended U.S. Individual Income Tax Return, corrects a previously filed Form 1040. When filing Form 1040-X, you adjust the income and deduction figures for the prior year to reflect the NOL carryback, which reduces the tax liability for that year and generates a refund.

Application for Tentative Refund (Form 1045)

Form 1045 is designed for a quicker refund process. Form 1045 is specifically used to apply for a quick refund resulting from the carryback of an NOL, an unused general business credit, or a net section 1256 contracts loss. This form requires information about the NOL, the original tax liability of the carryback year, and the recalculated tax liability after applying the NOL. Form 1045 is filed separately and processed faster than Form 1040-X.