Limits on Tax Deduction of Business Losses

Starting a business has the obvious aim of generating income, but you might experience losses in some years. Although spending more than your revenue is particularly common in the initial year of operation, it can occur whenever unusual circumstances arise that reduce profitability below zero.

Business profits are reported on the personal income tax returns of proprietors, partners in a partnership and shareholders of S-corporations. These are the most common business structures for tax purposes. Business losses are typically deducted on the income tax returns of owners. A business loss offsets income from other sources, thus reducing your overall taxable income. However, the amount of business loss an owner may deduct is limited by at-risk rules.

This means that you must identify how you paid for a business loss. You are at risk for the amount of personal funds invested in the enterprise as well as debt for which you’re personally liable or have pledged property to secure a loan (other than property already used by the business).

You’re only allowed to deduct the losses of a business to the extent you lost your own money and are therefore at risk of not getting it back from future profits. Moreover, a loss you can deduct reduces your at-risk amount in the business for the subsequent year. Fortunately, a loss denied from not being at risk carries over to succeeding years for deduction when you are personally at risk. Determining your at-risk amount is therefore an annual process to conduct with your tax accountant.