Business Losses and What You Can Do With Them

When your business loses money, that loss generally travels with you onto your personal tax return, where it can offset other income you have — a spouse's wages, investment income, a side job. That's exactly why loss years draw extra scrutiny from the IRS: a paper loss that reduces your tax bill on income from elsewhere is valuable, and the tax code runs it through several checkpoints before letting you use it that way. Understanding those checkpoints, in order, is the difference between a loss that helps you this year, a loss that has to wait, and a loss the IRS disallows altogether.

This article walks through that gauntlet at a framework level — what each checkpoint is, why it exists, and where to confirm the current rules — not the actual numbers for your return. That part is a job for a CPA.

Start here: how a business loss reaches your personal return

If you're a sole proprietor (filing Schedule C), a partner in a partnership, a member of a multi-member LLC taxed as a partnership, or a shareholder in an S corporation, your business generally does not pay its own income tax. Instead, its profit or loss "passes through" and lands on your personal Form 1040. This site's guides on choosing a business structure and how an LLC is taxed cover that pass-through mechanic in general — the point here is narrower: when the number that passes through is negative, the tax code doesn't just let it flow through automatically. It has to clear four gates first, and they apply in order.

Gate 1: Do you have basis?

You can only deduct a loss up to what you actually have invested in the business — your "basis." Basis generally starts with what you put in (cash, property, and in a partnership or S corp, certain loans you personally made to the business) and moves up and down each year with profits, contributions, distributions, and losses already used. If losses exceed your basis, the excess isn't deductible yet — it's suspended and carried forward until you add more basis in a future year. This is a common surprise for owners of S corporations and multi-member LLCs, where basis tracking is its own ongoing bookkeeping task, not something to reconstruct from memory at filing time.

Gate 2: The at-risk rules

Even if you have basis, a related set of rules limits your deduction to what you're actually "at risk" in the activity — generally your own money and debt you're personally liable to repay. Money protected through nonrecourse financing (debt the lender can collect only against the property, not against you), someone else's guarantee, or arrangements that insulate you from real economic loss typically doesn't count. There are exceptions — notably, certain "qualified nonrecourse financing" secured by real property can be treated as at-risk — which is one reason real estate ventures need their own look rather than a rule of thumb. Like a basis shortfall, an at-risk shortfall doesn't kill the loss; it suspends the disallowed portion until your at-risk amount grows.

Gate 3: The passive activity rules

Next comes one of the most misunderstood limits: the passive activity loss rules. If you don't materially participate in the business — meaning your involvement doesn't meet the IRS's tests for regular, continuous, substantial participation — your loss is treated as "passive." Passive losses can only offset passive income, not your wages or a spouse's salary. Without passive income to absorb it, the loss is suspended until you have some, or until you dispose of the activity. The rule exists to stop taxpayers from buying paper losses in ventures they aren't actually running, purely to shelter unrelated income.

If you're actively working your own business day to day, you'll usually clear this gate. Rental activities are the big asterisk: they are generally treated as passive by default even when you work at them, with limited exceptions, so anyone holding rentals alongside an operating business should confirm how their activities are treated rather than assume.

Gate 4: The excess business loss limitation

If your loss survives basis, at-risk, and passive-activity screening, there's one more federal ceiling for noncorporate taxpayers — individuals, estates, and trusts, but not corporations: the excess business loss limitation, sometimes called the "461(l)" limitation after its Internal Revenue Code section. It caps how much net business loss, in total, you can use in a single year to offset non-business income — wages, interest, dividends, capital gains. Losses above that cap aren't lost; the disallowed amount is treated as a net operating loss carryover to later years.

Two things worth knowing. First, this limitation is not a temporary provision waiting to expire — legislation enacted in 2025 made the disallowance permanent. Second, the dollar threshold is set by statute, adjusted for inflation annually, and differs for single versus joint filers, so don't rely on a figure from last year or an undated article — confirm the current-year threshold using Form 461 and its instructions at irs.gov.

What's left becomes a net operating loss (NOL)

If, after all four gates, your business deductions still exceed all your income for the year, you generally have a net operating loss. The rules changed significantly in recent years and are easy to get wrong from memory or an old article:

• Carryback is mostly gone. For most recent-year NOLs, you can no longer carry the loss back for a refund on a prior return the way older rules allowed. Narrow exceptions remain for certain farming losses and certain insurance company losses. The temporary pandemic-era carryback rules have expired — do not rely on articles describing them. Confirm your situation at irs.gov.
• Carryforward is generally indefinite, not a fixed number of years — but the loss can typically offset only a percentage, not all, of your taxable income in any one future year, so a large NOL may take several profitable years to fully use.
• Individuals, estates, and trusts figure and track this on the applicable IRS form and worksheets; check irs.gov for the current form and instructions.

A suspended loss is not a lost loss

Worth saying plainly, because it's easy to panic in a bad year: a loss stopped at basis, at-risk, passive-activity, or the excess-business-loss gate is not gone. In every case, the disallowed amount is preserved and carried to a future year, waiting for the condition that unlocks it — more basis, more at-risk investment, passive income to absorb it, or simply next year's return. Good bookkeeping is what keeps those suspended amounts from being forgotten or miscalculated years down the road.

The hobby-loss trap: losses only work if the IRS agrees you're a business

All of the above assumes the IRS agrees you're running a business with a genuine profit motive. If an activity loses money year after year and looks more like a hobby or a passion project, the IRS can apply the "not-for-profit activity" rules (often called the hobby-loss rule) and disallow the loss against other income entirely — regardless of whether you cleared the basis, at-risk, and passive-activity gates. Income from the activity still has to be reported either way.

The IRS weighs a list of factors and says plainly that no single one controls: whether you carry on the activity in a businesslike way with complete and accurate books, the time and effort you put in, whether you depend on the income, whether personal pleasure or recreation is driving it, your expertise and your advisors', whether you've changed methods to improve profitability, whether you've made a profit in some years and how much, and whether the assets may appreciate. It's one more reason real bookkeeping and a separate business bank account matter beyond organization — they can determine whether a loss is usable at all. See the IRS's guidance on telling a hobby from a business at irs.gov.

What to do

1. Keep basis and at-risk records current every year, not just at tax time — have your CPA or bookkeeper track the schedule annually, especially in an S corp or partnership.
2. Track your material participation with a log of hours and involvement, especially with more than one business or rental interest.
3. Don't assume last year's dollar thresholds still apply. The excess-business-loss cap adjusts annually — confirm the current figure via Form 461 instructions at irs.gov.
4. Ask specifically about suspended losses when you switch preparers or software — carryforwards are easy to lose track of in the switch; request the carryforward schedules from your prior return.
5. Bring a loss year to a CPA, not just tax software. This is where a preparer earns their fee — basis, at-risk, passive-activity, and excess-business-loss rules interact, and getting the order wrong can overstate what you deduct (inviting an IRS notice) or understate it (leaving a deduction on the table).

Note that many states do not follow the federal loss rules exactly — some decouple from the federal NOL or excess-business-loss provisions, and the carryforward you claim federally may not match what your state allows. Check your state tax agency's guidance or ask your preparer rather than assuming the federal answer carries over.

If the business itself is failing rather than just having a bad year, this site's bankruptcy coverage explains business bankruptcy options, including sole-proprietor filings and what happens to a personal guarantee — a different question from the tax treatment of a loss, worth reading separately.

Frequently asked questions

Can I just deduct my full business loss against my spouse's salary this year?

Only if the loss clears all four gates: enough basis and at-risk amount, material participation (so it isn't passive), and it's within the excess-business-loss cap for the year. If it clears all of those, yes — that's how pass-through losses are designed to work. If it doesn't clear one gate, the disallowed portion carries forward instead.

Does forming an LLC change any of this?

Not by itself. An LLC has no tax classification of its own: by default a single-member LLC is disregarded (Schedule C) and a multi-member LLC is taxed as a partnership (Form 1065), and either can elect to be taxed as an S corporation or C corporation. The default treatment runs through the same basis, at-risk, passive-activity, and loss-limitation framework as a sole proprietorship or partnership. Forming an LLC changes your liability exposure, not automatically your taxes. Electing S-corp or C-corp taxation changes some mechanics, particularly basis tracking — a conversation for your CPA before you elect, not after a loss year.

I've lost money for several years straight. Am I automatically a "hobby" now?

No. The IRS says no single factor controls, so no particular number of loss years automatically reclassifies you. But a pattern of losses is one factor weighed alongside your recordkeeping, expertise, time and effort, and whether you run the activity in a businesslike way. Losses combined with sloppy records and an activity that looks personally enjoyable is the higher-risk combination. Talk to a CPA about documenting your profit motive.

Do I need to file anything special to carry a loss forward?

Generally yes — suspended losses, at-risk carryforwards, and net operating losses all need to be calculated and reported on the applicable IRS forms for the years they arise and the years they're used, including Form 461 for the excess-business-loss limitation. This is form-specific work; a CPA or free help from the IRS, SBA, or a state Small Business Development Center is the right resource before you file.

This article is general information, not legal, tax, or financial advice, and does not create an attorney-client or accountant-client relationship. For guidance on your specific situation, consult a qualified CPA or tax attorney, or use free resources from the IRS (irs.gov) and the Small Business Administration (sba.gov).