Small business owners by their nature are optimistic, as evidenced by various surveys (e.g., GGV Capital found that 83% of owners thought they’d do better in 2021 than in 2020). Despite signs of recovery, many businesses are still in the red and may continue to experience financial losses for some time to come.
Losses may impact 2020 income tax returns as well as returns for 2021. If you own a sole proprietorship, partnership, limited liability company (LLC), or S corporation, the tax law calls you a noncorporate taxpayer. As such, you report your share of business losses on your personal return. But limitations apply to curtail what you can write off in any year.
Here are the key limitations to watch on 2020 returns being filed in 2021 as well as 2021 returns filed next year.
Excess business losses
An excess business loss is the amount by which the total deductions attributable to all of your trades or businesses exceed your total gross income and gains attributable to those trades or businesses, plus $250,000 (or $500,000 in the case of a joint return) as adjusted for inflation. Due to COVID-19, the excess business loss limit was suspended for 2018, 2019, and 2020; it applies again in 2021. The thresholds for 2021 are $262,000 ($524,000 on a joint return).
If your share of losses in 2021 are greater than the limit, they aren’t entirely lost. Instead, they become part of your net operating losses (NOLs), discussed next.
Net operating losses
Basically, net operating losses (NOLs) result when business expenses exceed business income, although there are various technical adjustments. Noncorporate taxpayers report NOLs on their personal returns based on their share of business income, expenses, and other adjustments.
Again, because of the pandemic, different rules apply for 2020 returns as compared with returns for 2021 and beyond.
- For 2020: NOLs are carried back 5 years to offset 100% of taxable income in those years unless the carryback is waived. Unused NOLs can be carried forward indefinitely until used up, but only offset 80% of taxable income in carryforward years. A noncorporate taxpayer can file for a quick refund on Form 1045 before the income tax return is submitted.
- For 2021: NOLs cannot be carried back, other than for farming businesses (which have a 2-year carryback). They can only be carried forward indefinitely to offset 80% of taxable income in the carryforward years.
Basis
Even if you manage to get through the hurdles of excess business losses and net operating losses, you cannot take write-offs for losses in excess of your basis. Basis means something a little different depending on your business organization:
- Partnership/LLC: basis is determined in part by the way in which you acquire your interest. If, as is typical, you acquired your interest by contributing directly to the business, then basis is your share of total contributions. If you put in 50% of the cash and property needed to start the business, your basis is 50% of total contributions. If you bought your interest from another owner, your basis is what you paid for your interest. Other rules apply if you performed services, inherited your interest, or received it as a gift. Whatever your initial basis, it is adjusted annually for certain items that increase or decrease it (e.g., your distributive share of business income increases basis while your distributive share of business losses decreases basis).
- S corporation: basis is the total of basis in stock and loans you made to the business. It does not include third party loans you merely guaranteed. As in the case of partnerships and LLCs, your basis is increased or decreased annually by certain items.
Some of this information must be included on the Schedule K-1 provided to each partner/LLC member, or S corporation shareholder. But it’s up to you, not your business, to keep track of your basis for tax purposes.
QBI deduction
If you aren’t profitable, you can’t take a qualified business income (QBI) deduction. This may be true for your 2020 return as well as your 2021 return. What’s more, losses will negatively impact your QBI deduction in the subsequent year. In other words, if you have a tax loss in 2020, it effectively reduces your 2021 QBI deduction even if you return to profitability.
Final thought
Naturally, business owners focus on being profitable and ways in which to reduce their resulting tax burden. However, the pandemic has flipped things upside down for many owners, and handling losses for tax purposes may take center stage…at least for a while.
