As the old cliché goes, you’ve got to spend money to make money. Sometimes that means the small business you’re trying to get off the ground has losses for a year or two, including a tax loss on your tax return. Does that big red number on the bottom of your return do you any good, or is it just the IRS’s way to mock you?
Let’s set up some boundaries for this post. I’m addressing people whose business income goes through their 1040, either as a sole proprietor or Single Member LLC filing a Schedule C, or a partner or S Corp shareholder who gets a K-1. If you’re filing a C Corp, this is not the post for you.
Net Operating Loss
Every now and then, someone comes up with a business plan so amazing that they’re making money from day one. For the rest of us, we have to suffer with losses from time to time to get our Tiger Petting Zoo off the ground. For tax purposes, a tax loss is called a Net Operating Loss, or NOL. And no, those losses do not just disappear in a cloud of smoke.
The general rule is that a Net Operating Loss can be carried back 2 years and forward 20 years, offsetting income in that time frame. If you haven’t used your Net Operating Loss in that time frame, it flies off into the ether.
Note that if you carry back your Net Operating Loss, you must go to the oldest year first (i.e. loss in 2015, you have to offset income in 2013 before offsetting income in 2014). You can, however, forgo the carry back and just carry the loss forward.
“But wait,” I hear a few people thinking, “I just started my business this year! How can I carry back my loss if I didn’t have business income last year?”
Amazingly, the IRS actually has your back here. For Net Operating Loss purposes, they consider SALARY business income.
Example: Let’s say you’re a high flying executive in 2014 and 2015, bringing in $500,000 of taxable income each year. You decide you’re sick of dealing with the even higher flying executive in your firm, so you head off on your own in 2016. Year 1 of your new business doesn’t go well, and you lose money, totaling a $100,000 Net Operating Loss. You can carry that $100,000 back and offset a portion of your $500,000 annual salary in the prior years (starting with 2014).
Yes, that could mean actual cash in your hand from the IRS in 2016.
Gettin’ That Money
To get that refund with the least amount of effort, you need to file a Form 1045 within a year of your Net Operating Loss. The form recalculates your prior year income AS IF the loss had happened in that previous year.
Missed the year deadline already? No problem, you can just go back and amend the prior year return as if the loss happened in that year (i.e. loss in 2016, so you amend your 2014 return, then your 2015 return if you still have losses)
Note that you have 3 years in which to do the amendment, or you’re out of luck on your carryback Net Operating Loss. You can, however, still carryforward the loss to future years.
Notes on Form 1045
Pull up the latest 1045, and you’ll probably agree that it’s fairly intimidating. Don’t get overwhelmed! It’s broken out in a couple different portions to try to make it easy to follow. On the 2014 form, the latest version available at time of writing, it’s set up as follows:
Page 1 – calculating the carryback. This is where you recalculate the prior year with the Net Operating Loss included. You’ll actually do this AFTER Schedule A
Page 2 (Schedule A) – This is actually calculating the Net Operating Loss in the current year. I’ll write details on this at the end of this post, but it’s to ensure your losses are BUSINESS losses only. Nonbusiness losses are not subject to the Net Operating Loss rules.
Page 3 (Schedule B) – Calculating how much Net Operating Loss you can take in each of the prior years.
NOTE: If you’re wondering why there’s 3 columns when you can only take the Net Operating Loss in the past 2 years, the answer is “it’s complicated.” Technically, you could have a short year that splits a single year into two different tax years, but you’re still allowed the Net Operating Loss for the full year. If you really want to get into that, though, I’d suggest getting your CPA, because you’re already are too much of a tax nerd for your own good.
The information above covered the general information for the Net Operating Loss. The deluge of text below gets into specifics of calculating your Net Operating Loss.
To determine the actual amount of Net Operating Loss, you have to come up with business loss only. The tax code as prescribed the following adjustments to come up with the allowed amount.
(1) You can’t have another Net Operating Loss causing a loss in the current year, i.e. you can only carry back or carry forward an NOL until your income is zero in the adjusted year.
(2) You can’t include any personal or dependent exemptions in calculating your Net Operating Loss.
(3) Capital gains and losses are messy. You can’t use any nonbusiness capital losses to offset your business capital gains. However, you can use business capital losses to offset nonbusiness capital losses, but ONLY after you first offset all business capital gains.
(4) Nonbusiness deductions (i.e. standard deductions, itemized deductions) only offset nonbusiness income, including passive investments like interest, dividends, annuities, endowments, etc. Business income includes salary, rental property.
(5) Casualty loss deduction, either for personal or business purposes, can be included in the Net Operating Loss calc, which is the only potentially nonbusiness deduction allowed.
(6) If you personally contribute to a retirement plan (i.e. deductible contribution as a self-employed individual), it is a nonbusiness deduction, so it can’t go into your Net Operating Loss Calculation.
(5) Domestic Production Activities Deduction is not allowed in a Net Operating Loss year.