How to make the most (or least) of business losses There are many strategies for minimizing your company’s tax bill. Not earning enough income to cover your expenses — though effective — isn’t the best approach. But for a new company that hasn’t yet started turning a profit or a mature business being squeezed by a sluggish economy, losses happen. No one likes to lose money, but the tax code softens the blow somewhat by allowing you to use a net operating loss (NOL) to offset income in previous or future years. Carrying back an NOL can be particularly beneficial because it can provide you with an immediate tax refund at a time when you may need an infusion of cash. Do you have an NOL? The concept behind NOLs is simple: You have an NOL if your business deductions in a given tax year exceed your business income for that year. For most companies, this determination is straightforward. It becomes more complicated for sole proprietorships because they need to separate business income and losses from personal income and losses. Sole proprietors, for example, don’t count personal exemptions, net capital losses and certain other nonbusiness deductions in determining whether they have an NOL on their individual tax returns. Should you carry forward or back? If your business has an NOL, you can use it to offset taxable income in the two tax years preceding the NOL year and claim a refund. For tax years beginning or ending in 2008, the American Recovery and Reinvestment Act of 2009 expands the carryback period to five years for qualified small businesses (defined as businesses having average gross receipts of $15 million or less applied over the three-year tax period ending with the tax year of the NOL). For certain losses attributable to casualty and theft, the carryback period is three years. Presidential-declared and certain other disasters allow a five-year carryback for businesses. Unused losses can be carried forward for up to 20 years. From an economic perspective, it’s typically better to carry NOLs back and claim a current refund than to hang on to the losses and use them in later years. In some cases, however, it may make sense to save your NOLs if you expect them to provide greater benefits in the future. For instance, businesses or business owners likely to move into a higher tax bracket in the near future may want to waive the carryback period. Does entity type matter? Business structure has a big impact on your ability to deduct NOLs. If your company is a pass-through entity — such as a partnership, S corporation or multiple-owner limited liability company (LLC) — losses are passed through to the partners, shareholders or members and deducted on their individual tax returns. It’s then determined at the individual taxpayer level whether or not an NOL is generated. Here’s where it gets complicated: Individual owners of pass-through entities can deduct business losses only to the extent of their adjusted tax basis, which isn’t necessarily the same as the balance in their capital accounts. Also, losses may be limited further by the at-risk and passive loss rules. (See “What about passive losses?”.) The rules apply differently depending on the type of entity. Consider basis, for example. Generally, the initial basis of pass-through entity owners is the amount they pay to acquire their interests plus the adjusted basis of any property they contribute to the company. During the life of the business, basis may be increased by the owners’ shares of company income, subsequent capital contributions and other factors. Basis may also be reduced (though not below zero) by the share of distributions, taxable losses and other items. One advantage of the partnership structure is that partners, under certain circumstances, can deduct losses in excess of their investment in the company. That’s because their tax basis is increased by certain partnership debt. On the other hand, an S corporation shareholder’s basis isn’t increased by corporate debt unless the shareholder makes a loan to the S corporation. Thus, S corporation shareholders generally can’t deduct losses beyond their company investment. An LLC member’s basis is also increased by business debt, but the at-risk rules make it difficult for members to deduct losses beyond their company investment. Because LLC members enjoy limited liability for company obligation, the portion of their basis attributable to company debt generally isn’t considered to be “at risk” unless they pledge nonbusiness property as collateral or otherwise assume personal liability for the debt. There’s also an exception for “qualified nonrecourse financing” — loans secured by real estate used in the business and meeting certain other requirements. What about passive losses? The ability of pass-through owners to deduct losses may also be limited by passive loss rules. These rules provide that owners can’t deduct passive business losses against nonpassive income — such as wages, interest, dividends and capital gains. For business losses to be considered “nonpassive,” an owner must materially participate in the business. Disallowed passive losses may be carried forward and offset against future passive income. The IRS allows owners to demonstrate material participation in several ways. Examples include working for the business for more than 500 hours a year or performing substantially all of the work in the business. If your business is a pass-through entity and you anticipate an NOL this year, you should determine whether the basis, at-risk or passive loss rules will limit your ability to deduct company losses. If they will, there may be moves you can make to increase your deductions, such as making additional capital contributions, lending money to the company or increasing the number of hours you spend working in the business. Don’t lose out on loss deductions Losing money is always upsetting. But if you expect your company to lose money this year or if it has suffered a loss in the last few years, don’t despair. There are several ways you can use these losses to generate refunds for previous years or cut your tax bill in the future. • |