Running a business comes with the risk of operating losses in any given year. But how that loss can be used to offset your personal income depends heavily on your company's legal structure. For partnerships and sole proprietorships, business losses flow through directly to owners' returns. With corporations, it gets more complicated.
In this guide, we’ll look at:
Understanding these nuances can mean major tax advantages when your business hits a rough patch.
Partnership and Sole Proprietor Loss Overview
For partnerships and sole proprietorships, business income or loss is reported on the owners' personal tax returns. The partnership files an informational Form 1065, but any losses flow through to the partners based on ownership share.
A sole proprietor reports business income and deductions on Schedule C, with net profit or loss going directly onto their individual Form 1040.
Therefore, any operating losses can be used to offset other income the taxpayer receives, such as wages, interest, dividends, and capital gains. The ability to directly deduct business losses against your personal income is a major advantage of partnership and sole proprietor structures.
S-Corp Loss Rules and Limitations
For S-corporations, only the owner-employee's reasonable salary is subject to FICA taxes. Net income distributions aren't considered "earned income."
You can use the S-corp's operating losses to offset other personal income. However, the IRS limits the amount you can deduct to the shareholder's adjusted basis in the corporation. Essentially, this is the shareholder’s capital investment in the S-corp plus earnings that have already been taxed but not distributed yet.
For example, if you have invested $50,000 cash into the S-corp and have $100,000 of undistributed profits that have already been taxed, your basis would be $150,000. If the S-corp then has a $200,000 loss one year, you can only deduct $150,000 on your personal return. The remaining $50,000 of unused losses are suspended but can be applied in future years to offset S-corp income.
C-Corp Loss Rules
For C-corporations, business losses do not flow through to shareholders' personal tax returns. Instead, C-corps can carry operating losses forward for up to 20 years to offset future corporate income.
There is also an option to carry back losses 2 years to amend previous returns and get refunds for taxes already paid. However, the carryback provision was eliminated by the Tax Cuts and Jobs Act for losses arising in 2018 or later.
A C-corp's net operating loss (NOL) carryforward is limited to 80% of taxable income in any given future year. So if the corporation has $100,000 of taxable profit in a carryforward year, only $80,000 of remaining NOLs can be utilized.
Shareholders cannot deduct C-corp losses directly on their personal returns. The losses remain trapped inside the C-corp entity to be used only on the corporate return.
LLC Loss Deductibility
For LLCs, loss deductibility depends primarily on whether the LLC elects to be taxed as a partnership or corporation:
Partnership LLCs - Owners deduct their share of LLC losses on their personal tax returns.
Corporate LLCs - No pass-through of losses. They are handled at the entity level.
Most multi-member LLCs default to partnership taxation if an election is not made. This provides the benefit of pass-through loss treatment to the LLC owners.
Single-member LLCs are disregarded entities by default from an IRS perspective. So for tax purposes, the sole LLC member reports LLC activity directly on their return without any special election needed.
Loss Deductibility Statistics
According to IRS data covering the period from 1980 to 2005, partnerships utilized net operating loss deductions much more frequently than C-corporations:
Partnerships - claimed NOL deductions in 40-50% of years
C-Corporations - claimed NOL deductions in 15-20% of years
This highlights the tax benefit of direct pass-through treatment for partnership losses compared to the limitations around carrying corporate operating losses forward.
Business Structures Comparison
To summarize, here is how loss deductibility differs across entity types:
Entity Type: Who Deducts Losses?
Partnerships: Directly deducted by partners
Sole proprietorships: Directly deducted by owner
S-Corporations: Limited deduction for shareholders
C-Corporations: No deduction for shareholders
As this comparison shows, being able to directly deduct pass-through partnership/sole proprietor losses provides a clear tax advantage compared to C-corps. S-corps fall in the middle.
Frequently Asked Questions
Below are some common questions around deducting business losses:
Can I deduct business start-up costs if the new business loses money?
Start-up costs like market research, training, and consulting prior to officially launching are subject to special deduction limits. Up to $5,000 in start-up costs can be deducted in the first year, with any excess amortized over 15 years.
Do I have to materially participate in a business to deduct losses?
For sole proprietorships and single-member LLCs, material participation is a given since there is only one owner. For partnerships/multi-member LLCs, you must materially participate under IRS rules to deduct losses against ordinary income.
Can inactive partners or investors deduct partnership losses?
Typically no. Passive partners who do not materially participate in the partnership cannot deduct operational losses against earned or portfolio income. Any losses generated are suspended.
Does vesting impact the deductibility of LLC losses?
No, vesting of ownership interests pertains to the timing of distributions, not tax loss deductibility. An LLC member's ability to deduct losses depends solely on material participation standards.
If my business shows a loss, do I have to make estimated tax payments?
No, incurring a business loss allows you to base estimated taxes on $0 income. Any prior year overpayments should be refunded after the loss year's return is filed.
Deducting Business Losses and Minimizing Your Tax Liability
The ability to deduct business losses hinges greatly on your company's legal structure and level of owner involvement. While partnerships and sole proprietorships offer pass-through treatment, limitations apply for S-corps and C-corps. Weighing factors like liability protection, number of owners, and eligibility for tax credits can impact which entity works best. If you need guidance on choosing a business structure or have questions on how your operating income or losses will translate to your personal tax return, the experts at United Tax are here to help. We work with business owners to ensure their entity type and participation align to maximize write-offs. Contact us for comprehensive tax preparation and proactive planning services designed to minimize your tax burden.
