Many business owners suffer huge losses each year; it’s perfectly normal in any business. To make sure that taxpayers start new businesses, the Internal Revenue Service permits entrepreneurs to deduct the size of their business losses on their income tax returns. They can then use this amount of their business loss to counterbalance other income for the past or future years.
To be able to claim a business loss taxpayers need to follow certain IRS guidelines.
Net operating losses
Business owners experience a net operating loss when the amount of the business expenses for the whole year surpasses the amount of income they generated. Net operating loss is considered in business terms but also applies when a taxpayer’s employee expenses go beyond his earned income.
Determining a Net Operating Loss
Taxpayers are required to deduct net operating losses on their tax returns. An example would be a business owner who has a $3,000 business loss in 2020 may be able to deduct the whole amount before the qualifying net operating loss is determined.
The taxpayer is, however, required to calculate other deductions from taxable income such as standard deductions, exemptions, and capital losses. These amounts are not included in the operating loss.
Carryover limit for operating loss
The year the net operating loss occurs deductions are not made. Taxpayers can choose to carry the losses backwards two years or forward 20 years. They can also utilize both options by carrying losses forward then back until it is used up. Net losses from some occupations may qualify for a lengthier carry back period. This means they can only carry their operating loss forward for 20 years until the whole loss is exhausted.
Getting a business off the ground could take time, you may not be able to get the business off the ground in the first few months of operation and the IRS recognizes this. It is still possible to deduct your expenses even without income. You have to meet certain IRS guidelines.
You can use your business loss to offset other income on your tax return and lower the overall tax bill. This will help them determine whether you are running a real business or operating a hobby.
Hobby vs business
The IRS will conclude that you are operating a business rather than a hobby, when you register a profit in a minimum of three out of the five years you have been in operation. This allows you to operate for a maximum of two years without profit. Be extra vigilant as auditors may develop an interest if you are constantly running on losses.
The IRS may still allow your deductions even if you show no profit for several years in a row. This will depend on several factors; here is a quick look at some of them.
- Do you conduct your affairs in a business-like manner and put all your time and effort into getting the business profitable?
- Have you made a profit from similar activities in the past?
- Are you trying to live off the business and support yourself?
- Is your failure to generate income as a result of circumstances beyond your control?
After they confirm these questions the IRS may conclude that you are running a legit business and in turn allow your business the expense deductions.
To prove that your intentions of running a business even though you are low on funds, you will need to keep worthy records of the expenses. Keep every other record that supports the deductions. Do not assume some records are useless the calendars and datebooks will help show the amount of time you spent on the business activities and the type of activities you undertook in trying to make the business profitable.
If possible show a business that you had done previously that had a slow start but eventually picked up and became profitable. It would also help if you threw in some copies of the ads, business plan and anything else that shows how invested you were in the business to succeed.
If in the first year of business the income is still not rolling in you have the option of a certain form 5213 Election to Postpone Determination. This will get you valuable time as it will postpone any IRS assessment until the fourth year of your business operation. You, therefore, get valuable time to show a profit up to 5 years.
Deductions that are not allowed
If the IRS after assessment determines you are not conducting a proper business, then they will not allow you to deduct your business expenses. Filing form 5213 will force the IRS to postpone their determination until your fourth year of operation. They may, however, disallow deductions on the tax returns you filed in the first year to the third which in turn will mean that you end up owing taxes and interests on those returns.