If you're like most small business owners, you won't see a
profit in your first year of operation. And as your business
grows, you may face one or more years in which your business's
expenses exceed its income. In other words, the business may
have a loss for the year.
Although it may be small comfort, if you have a loss and your
business is organized as a sole
proprietorship, you'll normally be able to deduct the loss
from your total income from other business ventures or from any
salary, wages, or other earnings. If the business loss exceeds
your total income for the year, any unused portion of the loss,
which is known in the tax laws as a net operating loss (NOL),
can be used to offset income and reduce taxes in another year.
The net operating loss deduction is an exception to the
general income tax rule that your taxable income is determined
on the basis of your current year's events. This deduction
allows you to offset one year's losses against another year's
income. A net loss from the operation of a trade or business,
casualty losses, and losses resulting from employee business
expenses are included in this computation, but losses from a
trade or business are the most common occurrence.
Calculating an NOL can be tricky and we suggest that, if you
have one, you consult a professional to help ensure you do it
correctly, or get the IRS's free Publication 536, Net
Operating Losses. The following discussion is intended to
give you a basic understanding of how NOLs work for sole
Other forms of business. If your business is organized
as a partnership, a multiple-owner LLC (which is treated as a
partnership), or an S corporation, different, even more
complicated rules apply.
Generally, a partner's share of the partnership loss
(including capital loss) is allowed only to the extent of the
adjusted basis of his or her partnership interest at the end of
the partnership's tax year in which the loss occurred (but
before reduction by the current year's loss). This is not
necessarily the same as the balance in the partner's capital
account. Any excess is allowed as a deduction in later years to
the extent that the partner's basis is increased above zero.
The rules for S corporation shareholders are similar, with
one major exception: a shareholder of an S corporation only
increases his or her basis in the shares by any loans made
directly from the shareholder to the corporation. Indebtedness
guaranteed by a shareholder does not increase basis. Thus, a
shareholder's basis in his or her interest will be less, in most
cases, than a partner's.
The partner's or shareholder's allowable loss may be deducted
by the partner on his or her individual returns as a business
loss, subject to the passive
activity rules. Although the partnership itself may not
carry the loss backward or forward to other years as a net
operating loss, the partners' shares of the loss may result in
net operating loss carrybacks or carryovers on their individual
returns. For more information on how this would work, consult
your tax advisor.
If your business is organized as a C corporation, any net
operating loss it suffers provides no tax benefit to the
shareholders. Such a loss can only be used by the corporation
itself: it may be offset against the income of its subsidiaries
(if any) if a consolidated return is filed, carried back against
past income, or carried forward to reduce future income. A
corporation can carry a net operating loss back two years and
forward 20 years. If net operating losses are anticipated by a
corporation, it may be beneficial to elect S corporation status
and pass the losses on to the shareholders.