Leveraging the Tax Code: Easing the Burden of Business Losses

Whether you're steering a fledgling startup or managing an established enterprise, financial setbacks are part of the business journey. Fortunately, the federal tax code serves as a valuable tool, offering relief by allowing businesses to leverage losses to offset taxable income in subsequent years, albeit within specific constraints.

Qualifying for a Deduction

The Net Operating Loss (NOL) deduction stands as a crucial provision addressing tax disparities between businesses with consistent income and those experiencing fluctuations. Essentially, it empowers the latter to average out their income and losses over time, thereby adjusting tax payments accordingly.

To qualify for the NOL deduction, your deductions for the tax year must surpass your income. Eligible losses can stem from various sources, including:

• Business (Schedules C and F losses, or Schedule K-1 losses from partnerships or S corporations)
• Casualty and theft losses from a federally declared disaster
• Rental property (Schedule E)

However, certain elements don't factor into the NOL determination, such as capital losses exceeding gains, exclusions for gains from the sale of qualified small business stock, nonbusiness deductions surpassing nonbusiness income, the NOL deduction itself, and the Section 199A qualified business income deduction.

Individuals and C corporations can claim the NOL deduction, while partnerships and S corporations, while ineligible, allow partners and shareholders to calculate individual NOLs using their respective shares of income and deductions.

Limitations and Changes

Before the Tax Cuts and Jobs Act (TCJA), taxpayers could carry back NOLs for two years and forward for 20 years, applying NOLs against 100% of taxable income. The TCJA brought changes, limiting NOL deductions to 80% of taxable income for the year and eliminating the carryback of NOLs (with certain exceptions). However, it introduced the perpetual carryforward of NOLs.

Should your NOL carryforward exceed your taxable income, you create an NOL carryover. Proper sequencing of multiple NOLs is essential, applying them against modified taxable income in the order incurred, beginning with the earliest.

Planning Ahead

Navigating the intricate web of tax rules concerning business losses, especially the interplay between NOLs and other potential tax breaks, requires strategic planning. HoganTaylor can guide you in charting the optimal course for your business.

Excess Business Loss Limitation

The TCJA introduced the "excess business loss" limitation in 2021, applicable to partnerships and S corporations at the partner or shareholder level. Noncorporate taxpayers can offset business losses only against business-related income or gain, up to a specified threshold. Excess losses become NOL carryforwards, subject to the 80% income limitation on NOLs.

Important: The excess business loss limitation, initially set to expire after December 31, 2026, now extends to tax years beginning before January 1, 2029, according to the Inflation Reduction Act.

In summary, understanding and strategically utilizing the tax code provisions, especially in the context of NOLs and excess business losses, can significantly mitigate the impact of business losses on your bottom line. If you have questions or need assistance in navigating these complexities, please reach out to a HoganTaylor Wealth or a HoganTaylor Tax advisor for assistance.