Utilizing Business Losses for Tax Benefits

Even the most well-managed companies can face challenging years. Fortunately, the federal tax code offers a strategy to mitigate the impact of these downturns. Certain losses, within specified limits, can be used to reduce taxable income in future years.

Eligibility for Net Operating Loss (NOL) Deduction

The NOL deduction is designed to level the playing field between businesses with consistent income and those with fluctuating earnings. It allows businesses to average their income and losses over several years, ensuring a fair tax payment.

You may qualify for the NOL deduction if your deductions for the tax year exceed your income. Typically, the loss must be related to deductions from your business activities (Schedules C and F losses, or Schedule K-1 losses from partnerships or S corporations), casualty and theft losses from federally declared disasters, or rental property (Schedule E).

Certain items are generally excluded when calculating your NOL, including capital losses that exceed capital gains, the exclusion for gains from the sale or exchange of qualified small business stock, nonbusiness deductions that exceed 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 are generally ineligible, partners and shareholders can use their shares of the business's income and deductions to calculate individual NOLs.

Changes and Limits Under the Tax Cuts and Jobs Act (TCJA)

The TCJA brought significant changes to NOL rules. Previously, NOLs could be carried back two years, forward 20 years, and offset up to 100% of taxable income. The TCJA eliminated carrybacks (except for certain farm losses), allowed carryforwards indefinitely, and capped the deduction at 80% of taxable income for the year.

If an NOL carryforward exceeds your taxable income for the target year, the unused balance may become an NOL carryover. Multiple NOLs must be applied in the order they were incurred.

Excess Business Loss Limitation

The TCJA introduced an "excess business loss" limitation effective from 2021. For partnerships and S corporations, this limitation is applied at the partner or shareholder level, after considering outside basis, at-risk, and passive activity loss limitations.

Under this rule, noncorporate taxpayers' business losses can offset only business-related income or gain, plus an inflation-adjusted threshold. For 2025, that threshold is $313,000 ($626,000 if married filing jointly). Remaining losses are treated as an NOL carryforward to the next tax year, subject to the 80% income limitation on NOLs.

Important Note

The Inflation Reduction Act extends the excess business loss limitation to tax years through 2028. Initially, the TCJA had scheduled it to expire after December 31, 2026.

Proactive Planning

Navigating NOLs and related restrictions can be complex, especially when coordinating with other deductions and credits. Thoughtful planning can maximize the benefit of past losses. Consult with us to determine the best approach for your situation.