Determining Excess Business Losses

When individual taxpayers face substantial business losses, certain federal income tax rules may come into play. Here’s what you need to know as you evaluate your 2024 tax situation.

Disallowance Rule

The tax rules can become complex if your business or rental activity incurs a tax loss, which is common during the early years. Initially, the passive activity loss (PAL) rules may apply if you are not significantly involved in the business or if it is a rental activity. Generally, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources. However, you can deduct passive losses that were disallowed in previous years (known as suspended PALs) when you sell the activity or property that generated the suspended losses.

If you overcome the PAL rules, you face another hurdle: you cannot deduct an excess business loss in the current year. For 2024, an excess business loss is defined as the excess of your aggregate business losses over $305,000 ($610,000 for married joint filers). For 2025, the thresholds are $313,000 and $626,000, respectively. Any excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards.

Deducting NOLs

Generally, you cannot use an NOL carryover, including one from an excess business loss, to offset more than 80% of your taxable income in the carryover year. Additionally, NOLs generally cannot be carried back to an earlier tax year; they can only be carried forward indefinitely. The requirement to carry forward an excess business loss as an NOL means you must wait at least one year to benefit from any tax savings.

Example 1: Partial Deductible Business Loss

A business owner is single and, in 2024, incurs a $400,000 loss from a start-up AI venture, which operates as a sole proprietorship. Although there is no other income or losses from business activities, the business owner has $500,000 of income from other sources (salary, interest, dividends, capital gains, etc.). The excess business loss for the year is $95,000 (the excess of his $400,000 AI venture loss over the $305,000 excess business loss disallowance threshold for 2024 for an unmarried taxpayer). The first $305,000 of the loss can be deducted against the earned income from other sources. The $95,000 excess business loss is carried forward to the 2025 tax year and treated as part of an NOL carryover.

Variation: if the 2024 business loss is $305,000 or less, the entire loss can be deducted against the income from other sources because there is no excess business loss.

Example 2: No Impact from Disallowance Rule

A married couple files jointly. In 2024, the husband incurs a $350,000 loss from rental real estate properties (after considering the PAL rules). The wife runs a small business as a single-member LLC treated as a sole proprietorship for tax purposes, incurring a $150,000 tax loss in 2024. The couple has no other income or losses from business or rental activities but have $600,000 of income from other sources. They do not have an excess business loss because their combined losses total $500,000, which is below the $610,000 excess business loss disallowance threshold for 2024 for married joint filers. Therefore, they can use their $500,000 business loss to offset income from other sources.

Partnerships, LLCs, and S Corporations

The excess business loss disallowance rule is applied at the owner level for business losses from partnerships, S corporations, and LLCs treated as partnerships for tax purposes. Each owner’s allocable share of business income, gain, deduction, or loss from these pass-through entities is considered on the owner’s Form 1040 for the tax year that includes the end of the entity’s tax year.

The Best Way Forward

As you can see, business losses can be complex. Contact us if you have questions or need more information about the best strategies for your situation.