We all know the old adage: “It takes money to make money.” As simple as it sounds, it can take time before the “make money” part catches up with the “takes money” part.
Business owners and sole proprietors regularly operate in the red before seeing the fruits of their labor. As an accountant, I regularly hear people ask, “How does losing money affect my taxes? Will I still get a refund if I have a loss?”
By the end of this post we will answer those questions, and, hopefully, give you some peace of mind about swiping that credit card.
What is a business loss?
A business loss is what happens when your expenses are greater than your income. In other words, you lost money.
Before I continue, a quick note: this article covers losses from businesses that you actively participate in — like your Schedule C side hustle. In other words, your effort is what is driving the success or failure of the business.
I won’t be covering “passive” losses, which include things like rentals and investments. Those have a totally different set of rules and requirements.
How does your business loss affect your taxes?
It’s not uncommon for businesses to have losses, especially in their first few years. While bleeding money is rarely a good thing, it can come in handy during tax time.
As a way of helping small business owners push through difficult years, the IRS allows you to reduce your taxable income using your business losses.
How to lower your taxes with a business loss
Let’s say you have $60,000 of W-2 income from your regular 9-to-5 job. In your spare time, you drive for Uber and Lyft.
Last year, you only made $1,000 from rideshare driving, but after tallying up your car expenses and other write-offs, you have $4,000 in expenses. Your Schedule C shows a “net loss” of $3,000 (1,000 - 4,000).
Your $3,000 loss can be used to offset your W-2 income. So instead of being taxed on $60,000, you’d be taxed on just $57,000.
This is why business write-offs are so important. Not only can they reduce your self-employment taxes, but a loss can help your overall tax situation as well.
Most freelancers and independent contractors consistently overpay on taxes because they don’t claim all of their write-offs. That’s why Keeper was founded: to help gig workers and self-employed people find their write-offs. The app is designed to scan your transactions and help you identify eligible transactions.
Do you get a tax refund if your business takes a loss?
Yes! At least, a business loss will never prevent you from getting a refund if you’re entitled to one already. And because a business loss can lower your other income, it might even increase your chances of getting one.
How much loss is too much?
There are limits to how much you can claim in a single year. For 2021, those limits are:
In other words, you can offset your income up to those amounts, but not beyond. Anything over that is called an “excess loss.”
You also can’t claim more in losses than you have in income. Bringing your taxable income down to zero is enough to maximize your benefits.
Let’s look at two examples of how this works.
When your loss is greater than the limit for your filing status
Pretend you have $300,000 in business losses and $280,000 in W-2 income. Assuming you’re a single filer, you can take $262,000 of your losses and only be taxed on $18,000.
Notice that, in this instance, you can’t take all of your business losses even though your income is greater than your losses. You’ve already hit the business loss limit, so there’s no way to bring your taxable income down to zero.
When your loss is greater than your income
Now, say you have $80,000 in business losses and $70,000 in W-2 income. You can claim $70,000 of your business losses and bring your taxable income to $0.
Your loss might be bigger than your income, but you can’t bring your taxable income below zero. In other words, there’s no way to claim all $80,000 in losses and force the IRS to give you a $10,000 refund. It doesn’t work like that.
In both examples, the loss is limited. Either because the income was already reduced to zero or because the loss limitations kicked in.
What happens to the loss you can’t take?
Good news: When you hit the loss limit, the amount you’re leaving on the table doesn’t just go away. The unused loss can be “carried forward” and written off in future years.
This is why any good tax professional will always ask to see the last three years of your returns — they’re looking for carryovers that could save you money.
After the Tax Cuts and Jobs Act passed in 2018, a very important change was made to carry forward rules. Your “net operating loss” (NOL) carryforward — meaning the amount that went unused in the previous year — is now limited to 80% of your taxable income.
How to carry your loss forward
Let’s unpack that. Returning to the first example above, you have a loss carryforward of $38,000 ($300,000 - $262,000).
Let’s say you quit your job early in the year to focus solely on your business, which had a small profit of $5,000. Your W-2 income was $35,000, so your combined taxable income is $40,000.
Prior to 2018, you could have used your entire prior year excess loss to lower your current year income. Unfortunately, now it’s limited to 80%. So you can only write off $32,000 ($40,000 X 80%). That makes your taxable income $8,000.
The remaining $6,000 of your loss ($38,000 - $32,000), though, can be carried over to next year.
Prior to 2018, a loss could only be carried forward for 20 years and carried back for two. Now it can be carried forward indefinitely but can’t be carried back at all.
Can you have a business loss every year?
This is the question we’re really all interested in. Most of us will never have to deal with loss limitations, but it’d be nice to offset your regular income by a few thousand dollars every year.
And for freelancers and gig workers, it’s not that difficult to pull together enough expenses to hit the mark. But are there any risks with claiming back-to-back losses?
As a matter of fact, there are. Too many consecutive losses and the IRS might just label your business a hobby. That would prevent you from claiming business deductions in the future while still being required to pay tax on your hobby income.
You read that right. No more write-offs. Zilch. Zero. Nadda. Kaputz. Basically, it’s the worst-case scenario.
And to make the nightmare worse, if they determine it should have been treated as a hobby all along, you might even be on the hook for back taxes and penalties.
Bottom line: don't try to inflate your write-offs are falsify write-offs to save money on your taxes. It's illegal and could get you into trouble.
How to avoid getting your business labeled as a hobby
Before you despair into a pint of Ben & Jerry’s, let’s talk about how to avoid this issue. The IRS only classifies businesses as hobbies if — after evaluating a number of variables — they determine that you aren’t trying to make a profit.
Reporting consecutive losses is their first clue that what you’re doing might be a hobby. (That, or you’re just bad at business.)
Using the “two out of five” ratio
To avoid the hobby treatment, try to demonstrate a profit 3 out of every 5 years.
To use technical jargon, this is called a "safe harbor."
I want to stress this isn’t a hard-and-fast rule. Many businesses — especially new businesses — have unavoidable losses for several years in a row. So not meeting the Safe Harbor guidelines doesn’t automatically mean you’re in trouble.
The IRS will evaluate your entire situation before deciding on your hobby status. Here are some of the factors they’ll consider (with the IRS-speak translated into plain English)
✓ Can you demonstrate you’re out for profit?
Translation: “Are you even trying?”
You have to be able to prove you’re actually trying to make money. They will want to see a business strategy, and plans to turn your losses into future profits.
✓ Do you have the right qualifications?
Translation: “Do you even know what you’re doing?”
If you work as a plumber, but have seven years of consecutive losses and can’t demonstrate any formal training, they might decide you do it just for fun…. After all, who doesn’t enjoy a good plunging to shake off the day?
✓ Do you depend on this income for your livelihood?
Translation: “Is this play money to you?”
It doesn’t have to be your bread and butter, but it strengthens your case if the income contributes to your livelihood in a meaningful way. Does it help pay off student loans or build your savings?
Be prepared to explain how you factor this income into your life.
At the end of the day, this IRS wants to know what’s true. That’s why overstating your expenses on your tax return is a dangerous game (not to mention, illegal). Having a loss is great for your tax bill, but it has to reflect reality.
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At Keeper, we’re on a mission to help people overcome the complexity of taxes. That sometimes leads us to generalize in our educational content. Please email firstname.lastname@example.org if you have questions.