Losing money in a given year is painful, but it does not have to be a complete loss when it comes to taxes. The IRS provides specific mechanisms that allow businesses to use losses in one year to offset income in other years, reducing their overall tax burden over time. Understanding how these provisions work can make a meaningful difference in how a business weathers a difficult period.
How Pass-Through Entities Handle Losses
How NOLs are handled depends on your business structure. Owners of pass-through entities, including S-Corporation shareholders, partners in partnerships, and members of LLCs taxed as partnerships, claim NOL deductions on their individual tax returns because losses from these entities flow through to the owners rather than being deducted at the entity level. Sole proprietors also claim NOL deductions on their individual returns subject to basis, at-risk, passive activity, and excess business loss limitations.
C-corporations, by contrast, claim NOL deductions at the entity level and follow somewhat different rules for calculating the loss.
The Excess Business Loss Limitation
For noncorporate taxpayers, including sole proprietors, partners, and S-corp shareholders, there is an additional layer to navigate: the excess business loss limitation. Under this rule, noncorporate taxpayers’ business losses can offset only business related income or gain, plus other income up to an inflation adjusted threshold. For tax years beginning in 2026, that threshold is $256,000 for individuals or $512,000 for married couples filing jointly. An excess business loss is generally the amount by which aggregate business deductions exceed aggregate business gross income or gain, plus the applicable threshold amount.
Any losses exceeding those thresholds cannot be deducted in the current year. Instead, disallowed excess business losses are automatically treated as NOL carryovers to the following tax year, preserving the tax benefit for future profitable years while deferring the immediate deduction. Importantly, the excess business loss limitation has been made permanent under recent legislation, not all NOL rules.
What is a Net Operating Loss?
A net operating loss (NOL) may happen when allowable deductions, after NOL-specific modifications, exceed gross income. To qualify as a deductible NOL, the loss generally must be attributable to deductions related to a trade or business, rental property, or a casualty or theft loss resulting from a federally declared disaster.
The NOL deduction was designed to reduce tax inequities between businesses with stable year to year income and those with fluctuating profits, essentially allowing net losses in one year to offset taxable income in other years.
How Do NOLs Work Today
The Tax Cuts and Jobs Act (TCJA) of 2017 significantly changed the NOL rules. Later legislation, including the CARES Act, temporarily modified those rules for certain years. For NOLs arising in tax years beginning after 2020, businesses generally cannot carry NOLs back to prior years, but they may carry them forward indefinitely. Exceptions apply for certain farming losses, which generally may be carried back two years, and for certain nonlife insurance companies.
For tax years beginning after 2020, NOL deductions attributable to post-2017 NOLs generally cannot exceed 80% of taxable income, computed without regard to the NOL deduction and certain other deductions. As a result, even businesses with large NOL carryforwards may not be able to fully offset taxable income in a profitable year.
Other Loss-Related Provisions to Know
Beyond NOLs, businesses that experience losses should also be aware of several additional rules that determine whether and how much of a loss can actually be deducted.
Basis limitations generally restrict deductible pass-through losses to the taxpayer’s tax basis in the ownership interest, such as a partner’s outside basis or an S corporation shareholder’s stock and debt basis.
At-risk rules under IRC Section 465 limit deductions to the amount you have economically at stake.
Passive activity loss rules under IRC Section 469 restrict losses from activities in which you do not materially participate from offsetting active or portfolio income. This includes things like rental activities, unless an exception applies.
These rules apply in sequence, and each must be cleared before a loss can offset other income or become an NOL.
Strategic Considerations
Because NOLs can no longer be carried back to prior years for most businesses, you cannot count on an immediate refund to ease a cash flow crunch during a difficult year. This makes proactive planning more important than ever. Businesses that anticipate a loss year should work closely with their CPA to model future profitability, understand when and how NOL carryforwards can be utilized, and evaluate whether any strategies exist to accelerate income into the loss year to make immediate use of the deduction.
A bad year does not have to define your tax picture for years to come, but taking full advantage of these provisions require knowing the rules and playing them correctly. Talk to the financial experts at RYBD to make sure your bad year does not turn into a bigger problem.
