Whether you are operating a new company that has not yet earned a profit or a mature business that has been squeezed by today’s volatile economy, business losses can happen. While no one likes to lose money, the federal tax code helps soften the blow by allowing businesses to apply their losses to offset taxable income in future years, subject to certain limitations.
Do You Qualify for the Deduction?
The net operating loss (NOL) deduction addresses the tax inequities that can exist between businesses with stable income and those with fluctuating income. It essentially lets the latter average out their income and losses over the years and pay tax accordingly.
You may be eligible for the NOL deduction if your deductions for the tax year are greater than your income. The loss generally must be caused by deductions related to your:
- Business (Schedules C and F losses, or Schedule K-1 losses from partnerships or S corporations),
- Casualty and theft losses from a federally declared disaster (personal or business), or
- Rental property (Schedule E).
The following generally are not allowed when determining your NOL:
- Capital losses that exceed capital gains,
- The exclusion for gains from the sale or exchange of qualified small business stock,
- Nonbusiness deductions that exceed nonbusiness income,
- The NOL deduction itself, and
- The Section 199A qualified business income deduction.
Individuals and C corporations are eligible to claim the NOL deduction. Partnerships and S corporations generally are not eligible, but partners and shareholders can use their separate shares of the business’s income and deductions to calculate their individual NOLs.
What Are the Limitations?
The Tax Cuts and Jobs Act (TCJA) made significant changes to the rules for NOLs. Previously, taxpayers could carry back NOLs for two years, and carry forward the losses 20 years. They also could apply their NOLs against 100% of their taxable income.
The TCJA limits the NOL deduction to 80% of taxable income for the year and eliminates the carryback of NOLs (except for certain farming losses). It does, however, allow NOLs to be carried forward indefinitely.
The CARES Act temporarily loosened the TCJA’s restrictions. It allowed NOLs arising in 2018, 2019 or 2020 to be carried back five years and removed the taxable income limitation for years beginning before 2021. As a result, NOLs could completely offset income.
The CARES Act provisions have expired, though. The 80% income limitation kicked in again for NOLs that arose in 2021 and going forward, and you generally can only carry forward NOLs arising in tax years after 2020 (with the exception for certain farming losses).
If your NOL carryforward is more than your taxable income for the year to which you carry it, you may have an NOL carryover. The carryover will be the excess of the NOL deduction over your modified taxable income for the carryforward year. If your NOL deduction includes multiple NOLs, you must apply them against your modified taxable income in the same order that you incurred them, beginning with the earliest.
Are Excess Business Losses Deductible?
Prior to the TCJA, noncorporate taxpayers generally could reduce their taxable nonbusiness income (for example, salary, capital gains, dividends or interest) with their aggregate business losses from pass-through entities or sole proprietorships. The TCJA, however, established an “excess business loss” limitation, which took effect in 2021. For partnerships or S corporations, the excess business loss limitation is applied at the partner or shareholder level, after the outside basis, at-risk and passive activity loss limitations have been applied.
Under the new rule, noncorporate taxpayers’ business losses can offset only business-related income or gain, plus an inflation-adjusted threshold. For 2022, that threshold is $270,000 ($540,000 if married filing jointly). For 2023, it rises to $289,000 ($578,000 for married filing jointly). The remaining losses are treated as an NOL carryforward to the next tax year. In other words, you cannot fully deduct them because they become subject to the 80% income limitation on NOLs, reducing their tax value.
Important: Under the Inflation Reduction Act, the excess business loss limitation applies to tax years beginning before January 1, 2029. Under the TCJA, it had been scheduled to expire after December 31, 2026.
How Does the Deduction Affect Tax Planning?
It is worth keeping in mind that, under the NOL deduction limits, a $1 loss sustained in the current year could end up being worth only 80 cents for tax purposes. This might affect your decision to, for example, claim bonus depreciation on a capital asset in the year of purchase.
If claiming bonus depreciation in year-one would result in a large loss, it might prove more advantageous from a tax perspective to skip it. By instead amortizing the expense, you can fully deduct the cost over the asset’s life.
The rules regarding the tax treatment of business losses are complex, especially when accounting for how NOLs can interact with other potential tax breaks. Contact our tax team to take the right next step.
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