From the perspective of your tax return, a business loss is a good thing. A business loss reduces your overall income, and thereby reduces your income taxes. For many small businesses, properly planning your tax strategy for the year means identifying whether you have a net loss for your business.
Of course, there comes some risk with having a net loss; the IRS can take an active interest in businesses with a loss, especially those that have a loss year after year.
Here are some smart strategies for deducting and preserving your business losses, as well as some information you need to know:
- If you’re going to have a business loss, some deductions should be deferred. For example, you might choose to use section 179 deductions instead of regular depreciation for assets. Section 179 deductions can’t produce or increase a loss and will carry over to next year.
- The IRS distinguishes between a hobby and a business. Tax experts have encouraged clients for years to convert certain hobbies into a business, resulting in a loss in order to bring down their income. The IRS, of course, has wisened up to this strategy. The general rule of thumb is that a business should report a net profit at least three out of every five years, otherwise it’s considered a not-for-profit-hobby.
- This means the burden of proof is high for new businesses. New businesses regularly have losses – sometimes significant losses – as they absorb startup costs. Depending on your type of business, you might have several years of losses before your business turns a profit. Be prepared for a fight with the IRS if you’re starting up your business and you’re not going to be showing a profit for the first several years.
- There are some specific criteria that the IRS uses to prove whether or not your business is motivated by profit, rather than being a hobby. For example, if you operate the business in a professional manner, you depend on the business for your livelihood, you can demonstrate attempts to increase profitability, or if you can expect a future profit based on the appreciation of assets, you can still prove it’s a business, not a hobby. There are a total of nine factors you can use to prove your profit motive, so become familiar with them in the event that you get audited.
- Losses in one year can optionally be carried forward to a subsequent year. If your business has a net operating loss of $20,000 this year, you can use that to offset a gain of up to $20,000 in a subsequent tax year. In this way, you can still have a business that’s profitable in one year (meeting the IRS’s guidelines of showing a profit three out of five years) yet keep the tax advantage from the previous loss.
- Carrying over a business loss puts restrictions on a change of ownership. For example, if you have a corporation with investors, you can’t change more than 5% of your ownership if you’re in a preservation plan. For many small businesses, this isn’t a concern, but you do need to know that you’re locked in under a preservation plan.
- Good recordkeeping is key to preserving business losses. You need to make sure you’re documenting everything that happens in your business. That means not only the obvious financial record-keeping such as maintaining receipts and current books, but also documenting things like client meetings, bids or jobs you apply for, and more. It means conducting yourself in a professional manner and being able to prove that, as well.
- You need to be proactive about your tax plan. One of the best ways to maximize the benefits of a business loss is to be proactive. You need to look at your business throughout the year and make decisions based on your tax situation. In some cases, making some last-minute purchases can put your business into a state of loss, especially if you’re just on the cusp between profitability and loss. If you have income from another source, you can also use that business loss to offset your tax burden and keep yourself in a lower tax bracket.
A business loss can be a significant source of tax savings. However, you need to do it right. Make sure you consult with your tax professional in order to maximize your tax savings from a business loss.
