It’s happened to a lot of us. This last year has been crazy, and many small businesses ended the tax year recording a loss. It’s also very common for businesses to record a loss for the first couple of years.
Recording a loss doesn’t mean your business has failed or is failing, and it’s not necessarily a bad thing unless it becomes a pattern. While you should definitely be looking at factors that might be holding you back, you should also be looking for ways to take advantage of the situation.
How you can do so depends on whether you are operating as a “pass-through” business where the profit is considered to be the owner’s income, or not. Most small businesses are handled this way. It also depends on how bad the loss was.
If you pay business taxes with your individual return, you can simply deduct the loss from your other income, or your household’s other income. This is typical if you are married filing jointly and your spouse has other income. This also affects S corporations, partnerships, and small LLCs.
In other words, you deduct the loss from your other income when you file taxes.
If your loss exceeds all of your income, then you have a net operating loss. This loss can be carried forward to offset taxable income in future years, reducing your liability. Handling this can be very complicated and requires the help of a tax professional.
Bear in mind that particularly for sole proprietors, the IRS may decide that if you keep filing a loss you are not seriously in business and they may rule that the income is, instead, hobby income. Hobby income can’t be deducted, and you can’t deduct expenses unless you itemize. The IRS generally reviews businesses that make a loss in three of the last five years, except for startups.
If you show a net operating loss too often, they may investigate you to try and work out what you are living on.
You can protect yourself from this by taking steps that demonstrate to the IRS that you are taking your business seriously. These include having a separate business account, keeping good records, and being at least partially dependent on the business. The IRS also looks at whether people are putting in an effort and doing their best to make a profit. Registering as an LLC or S corp can definitely help your case. You should also keep up with business licenses and the like.
If your business tends to be borderline, then you might be tempted not to take all of your deductions. You are, in fact, technically required to take all legitimate deductions. What you can do, however, is put off large purchases until the next year to avoid going into the red. One exception is the home office deduction, and you should ask your tax adviser whether you should take it or not.
If your business is incorporated as a C corporation, the loss belongs entirely to the business. The losses must be carried off and deducted from a future year’s profits. You can also ask for an extension if you think you are going to make a net operating loss in the next year.
With a C corp, personal income is not counted when determining a net operating loss. Be aware that if you change a C corp to an S corp, you lose the net operating loss that you could otherwise carry over.
If your business is making a loss, then it is not the end of the world, but you should be considering how to adjust your operations to make more money. You should also talk to a tax advisor about how best to take advantage of this temporary setback to reduce future tax liability and strengthen your business for the future.