Figuring out taxes can be tricky, right? One question that comes up a lot is about using tax losses, which are like financial setbacks, when your business is actually making money, known as earnings before taxes (EBT). Essentially, can you still use those past losses to lower your current tax bill even though your business is doing well? This essay will break down this question and help you understand the rules and situations involved.
Understanding the Basics
Yes, in many cases, you can still use tax losses, even when your business has positive EBT. Tax losses are like “credits” you can use to reduce the amount of taxes you owe in the future. The IRS (the government’s tax people) allows this to give businesses a break when they have a rough year. However, there are some rules and limits on how you can use these losses, and that’s what we’ll explore.
Net Operating Losses (NOLs)
One of the main ways businesses use tax losses is through something called a Net Operating Loss (NOL). An NOL happens when your business expenses are higher than your income for the year. This creates a loss. The cool thing is, you can often use this loss to reduce your taxes in other years.
Imagine your business had a bad year, with $100,000 in losses. You might be able to use that $100,000 loss to reduce your taxable income in a future year. The idea is to even things out. This helps businesses because they can’t always control when they make money. It allows them to get a tax benefit even if the loss occurred in a year the company didn’t make profits.
The rules around NOLs have changed over time. Before 2018, businesses could usually “carry back” their NOLs (use them to get a refund on taxes from previous years). After 2018, the rules changed. Now, you can usually carry forward your NOLs indefinitely (use them in future years) and only offset up to 80% of your taxable income in any given year.
Here’s a quick look at the general steps:
- Figure out your NOL for the current year.
- Decide whether to carry it back (if allowed, and if it benefits you more) or carry it forward.
- Apply the NOL to reduce your taxable income in the chosen year, subject to the 80% limit.
- File the right tax forms to claim the benefit.
Tax Loss Carryforward Limitations
Even if you have losses, there are limits to how much you can use each year. One major limit is the 80% rule mentioned earlier. This means you can only use your NOL to reduce your taxable income by up to 80% in any given year. This can significantly impact the overall benefit you receive from the losses.
Also, the amount of losses you can use each year can be limited depending on the size and structure of your business. For example, if a company changes ownership, like being bought by another company, it might change the amount of losses it is allowed to use.
If your company is doing really well in a given year, with high earnings, you may not be able to use all your accumulated losses immediately. Because of the 80% limit, you’ll have to “save” some of your losses for the following year. This makes planning and budgeting a little more complex.
Here’s a simplified example:
| Year | Taxable Income | NOL Available | NOL Used | Taxes Owed |
|---|---|---|---|---|
| 2023 | $200,000 | $300,000 | $160,000 (80% of $200,000) | Depends on tax rate |
| 2024 | $300,000 | $140,000 (remaining from 2023) | $240,000 (80% of $300,000) | Depends on tax rate |
Change of Ownership
Another factor that affects your ability to use tax losses is a change in ownership of your business. If a company is bought or if there’s a major change in who owns the business, the IRS might restrict how much of the accumulated losses can be used. This is to prevent people from buying a business just to use its tax losses.
The rules here are complex and depend on how much ownership changes hands and over what period of time. If more than 50% of the company changes ownership, it’s likely that the ability to use prior year losses will be limited. This is why it’s important to consult with a tax advisor if your company is involved in a merger, acquisition, or other change in ownership.
Here are some things that can trigger a change in ownership:
- A sale of the business.
- A merger with another company.
- A change in the ownership of company stock.
- A restructuring of the business.
The limitations generally involve either reducing the amount of the loss that can be used each year or, in some cases, completely disallowing the use of the loss. The IRS wants to make sure the tax break is going to the original business that incurred the loss, and not to a new owner looking for a tax benefit. This prevents the use of tax losses to create an unfair advantage.
Specific Tax Situations
Certain types of businesses or industries might have special rules or limitations when it comes to using tax losses. For example, there could be unique regulations for things like farming, real estate, or certain types of investments. These specific tax situations can affect how and when you can use your tax losses.
In the real estate industry, for example, passive activity losses are handled differently. There are limits on how much of these losses you can deduct in a year if you don’t actively participate in the business. This is to prevent real estate owners from using losses from their real estate investments to offset income from other sources.
Another example is with investments. Some losses from selling stocks or other investments can only be used to offset gains from those investments. They might be limited to $3,000 per year against other types of income.
For this reason, it’s always important to consult with a tax professional who is familiar with your specific business and industry to make sure you are using your losses correctly and taking advantage of any applicable tax benefits.
The Alternative Minimum Tax (AMT)
The Alternative Minimum Tax (AMT) is a different way of calculating taxes, and it can impact the use of tax losses. It’s designed to ensure that taxpayers with high incomes pay a certain minimum amount of tax, even if they have a lot of deductions and credits.
Under the AMT, some deductions and credits, including the full amount of the NOL, might not be allowed. The AMT is a parallel tax system, and its rules differ from the regular tax rules. The idea is that you calculate your tax liability two ways: under the regular rules and under the AMT rules. You pay the higher of the two.
If you have a lot of tax losses, it’s important to consider the AMT because it might limit the benefit you get from those losses. This means you may end up paying more in taxes than you would if you only used the regular tax rules.
Here’s how the AMT generally works:
- Start with your taxable income.
- Add back certain deductions and tax preference items.
- Subtract an exemption amount.
- Multiply by the AMT tax rate.
- Compare the AMT to your regular tax.
- Pay the higher of the two.
Planning and Record Keeping
Proper planning and record keeping are crucial for making the most of your tax losses. You need to keep accurate records of your income, expenses, and any losses you’ve incurred. You should also understand the rules for carrying over losses and how they apply to your specific situation.
Work with a tax advisor or accountant who can help you:
- Track your losses.
- Determine when and how to use them.
- Make sure you comply with all the rules.
You’ll need to track when the losses occurred, how much they were, and how much you’ve used in previous years. If you don’t keep good records, you could miss out on tax benefits or, worse, get into trouble with the IRS. Also, consider tax planning. This involves taking steps now to plan how you’ll use those losses in the future to minimize your tax liability.
Here’s a quick look at some record-keeping essentials:
- Keep detailed records of all income and expenses.
- Document the nature of the loss.
- Track carryover amounts and any limitations.
- File all relevant tax forms.
Conclusion
In conclusion, while it’s generally possible to use tax losses even when your business has positive EBT, there are important rules and limitations to consider. These include the 80% limit, rules about changes in ownership, industry-specific regulations, and the AMT. Proper planning, record-keeping, and professional advice are key to maximizing the benefits of your tax losses while staying compliant with tax laws. Understanding these rules will help you manage your business’s finances effectively and make informed decisions about how to handle your taxes.