Your business can lose money in a tax year for many reasons, including a bad economy or theft or casualty losses. When this occurs, the Internal Revenue Service allows you to use your losses against your income in future or past years for federal tax purposes. You might even be able to deduct your losses from your state taxes, but the rules for this vary from state to state.
Losses Can Subtract From Other Income
Some business owners aren't solely self-employed but have other earnings separate from their business. If you have other income, your business loss first applies to reducing this income in the current tax year. If you had $20,000 in W-2 income from an employer, $2,000 in passive interest income, and $18,000 in business losses, you would pay tax on only $4,000 of income, or $22,000 minus $18,000.
You Can Apply Your Loss to Past Tax Years
If you earn nothing other than business income, or if your net operating losses exceed your other income, you can use the deficit to earn a refund from the IRS for taxes you paid in previous years. This carryback period is usually two years, although a three-year rule applies if your net operating loss is the result of theft or a casualty. Typically, you would first use your loss against the tax return you filed two years ago. Depending on the extent of your loss, you might have some left over. You could then apply this portion to your previous year's return. If there's still any loss remaining, you must carry it forward and apply it to your future year's return.
For example, if you have $50,000 in losses in the current tax year, and if your taxable income was $30,000 two years ago and $15,000 last year, you'd get a refund for taxes paid in both those years and you could deduct $5,000 from your taxable income next year.
You Can Carry Your Losses Forward
You also have the option of waiving your carryback period and using all your losses going forward for up to 20 years. You might do this if your losses in the current year were due to some catastrophic event that's not likely to repeat itself. If you expect your business to thrive next year, you can waive the carryback period and use all your losses going forward. However, after you commit to this decision, you can't change your mind if your business doesn't do as well as you expect.
Not All Deductions Qualify
Calculating your net operating loss can be complicated, and you may need the help of a tax attorney. Typically, you must add back certain deductions you take on your current return to determine your loss, such as dependent exemptions, your personal standard exemption if you took one, capital losses, and any other non-business deductions. The resulting number is your net operating loss from business.
A Tax Lawyer Can Help
The law surrounding net operating losses is complicated. Plus, the facts of each case are unique. This article provides a brief, general introduction to the topic. For more detailed, specific information, please contact a tax lawyer.