Can Business Losses give tax relief?

Even well-managed companies can experience difficult years. The federal tax code allows for a strategic approach to lessen the effects of these challenges. Certain losses, within specified limits, can be used to reduce taxable income in future years.

Who qualifies?

The net operating loss (NOL) deduction helps create a level playing field between businesses with steady income and those with fluctuating income. This deduction allows companies with variable earnings to average their income and losses over multiple years and pay taxes accordingly.

You may qualify for the NOL deduction if your deductions for the tax year exceed your income. Typically, the loss must arise from deductions related to:

1. Business operations (losses reported on Schedules C and F, or Schedule K-1 losses from partnerships or S corporations),

2. Casualty or theft losses due to a federally declared disaster, or

3. Rental property (losses reported on Schedule E).

However, the following items are generally not allowed when calculating your NOL:

• Capital losses that surpass 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 can claim the NOL deduction. Partnerships and S corporations typically do not qualify. Still, partners and shareholders can calculate their NOLs using their respective shares of the business’s income and deductions.

What are the changes and limits?

Before the Tax Cuts and Jobs Act (TCJA), Net Operating Losses (NOLs) could be carried back for two years and carried forward for up to 20 years, allowing them to offset 100% of taxable income. However, the TCJA brought significant changes to this process:

1. Carrybacks have been eliminated, except for certain farm losses.

2. Carryforwards are now permitted indefinitely.

3. Deductions for NOLs are capped at 80% of taxable income for the year.

Suppose an NOL carryforward exceeds your taxable income for the target year. In that case, the unused balance may become an NOL carryover to subsequent years. Additionally, multiple NOLs must be applied in the order in which they were incurred.

What’s the excess business loss limitation?

The Tax Cuts and Jobs Act (TCJA) introduced a limitation on “excess business losses,” which became effective in 2021. For partnerships and S corporations, this limitation applies at the individual partner or shareholder level, after considering outside basis, at-risk rules, and passive activity loss limitations.

According to this rule, non-corporate taxpayers can only use their business losses to offset business-related income or gains, along with an inflation-adjusted threshold. For the year 2025, this threshold is set at $313,000 for single filers and $626,000 for those married filing jointly. Any remaining losses are classified as Net Operating Loss (NOL) carryforwards to the following tax year. This means that taxpayers cannot fully deduct these losses upfront, as they will be subject to the 80% income limitation applied to NOLs, reducing their overall tax benefit.

Important: Under the Inflation Reduction Act, the excess business loss limitation applies to tax years through 2028. Under the TCJA, it had been scheduled to expire after December 31, 2026. Noite: Congress may still act to further extend these provisions.

Plan proactively

Navigating net operating losses (NOLs) and their related restrictions is complex, especially when coordinating with other deductions and credits. Careful planning can maximize the benefits of previous losses. Please call me at 856-665-2121 if you have questions.

RJC