Running a small business comes with its ups and downs. Sometimes, despite your best efforts, you may face a year of financial losses. The good news is that you can potentially leverage these losses to reduce your overall tax burden. Here is what you need to know about writing off small business losses on your taxes.
Utilizing business losses for tax benefits
If the structure of your business is that of a sole proprietorship, limited liability company (LLC), partnership or S corporation, you can claim business losses on your tax return. It means you may be able to offset your income from other sources with the losses incurred by your business. However, it is important to be aware of certain limitations and rules that come into play.
At-risk and passive activity rules
At-risk rules restrict the deductions you can claim on your taxes for certain activities that may lead to financial losses. These rules apply to individuals and closely held corporations, mostly owned by a few people. The rules limit the deductions you can take based on the money you have personally invested in those activities. You can calculate and report your at-risk situation using IRS Form 6198.
On the other hand, passive activity rules limit deductions for losses incurred from business activities in which you do not actively participate. These rules apply to rental activities and investments. The difference is that here, you act as an investor or shareholder without substantial involvement. However, if you qualify as a real estate professional, these rules may not apply to your rental activities.
Excess loss rules and potential of tax loss carryforwards
Excess loss rules come into play when your total business deductions surpass your gross income from the business, surpassing certain threshold amounts. For single taxpayers, the threshold is $262,000, and for joint tax returns, it is $524,000. Any losses exceeding these limits are considered excess losses. You cannot claim them on your year’s tax return.
Even if you cannot use excess immediately, you can carry them forward to future tax years, subject to certain limitations. The 2017 Tax Cuts and Jobs Act allows you to carryforward business losses indefinitely, but you can only deduct up to 80% of your taxable income in any given year. Unfortunately, tax loss carrybacks are no longer available.
While experiencing small business losses can be challenging, understanding the tax implications and associated opportunities is crucial. You can minimize your tax liability by leveraging the appropriate rules and limitations.
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