Writing Off Losses on Your Taxes

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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When you sit down with your accountant to do the taxes for your business, it's important to keep in mind that you can deduct your company's losses on your taxes — provided that you meet certain requirements.

Writing Off Business Losses

In order to ease the impact of losses on a growing business, the IRS offers business owners the chance to write off a net operating loss — a loss where your expenses for the year are more than your income — as well as unpaid invoices. The IRS's Form 1045 is used to calculate what portion of your business losses can be written off on your taxes. Depending on the situation, you can choose to carry back your net operating loss over the past two years or carry it over into future years in order to be able to reduce your future taxes with past losses. 

What you can write off is limited by several rules. The IRS does not allow you to deduct the following when calculating a net operating loss:

• Any deduction for personal exemptions
• Capital losses in excess of capital gains
• The section 1202 exclusion of 50% of the gain from the sale or exchange of qualified small business stock
• Nonbusiness deductions in excess of nonbusiness income
• Net operating loss deduction
• The domestic production activities deduction

Essentially, these limitations can cap the total losses you can write off on your taxes. Form 1045 walks you through the process of calculating the true amount of your net-operating losses that you can write off.

Writing Off Unpaid Invoices

If you find yourself in a positon where a client hasn't paid an invoice, you may be able to write it off on your taxes so that you don't get hit quite so hard by a client disappearing. However, you do have to use the accrual method of accounting in order to be eligible to deduct those unpaid invoices on your taxes. That means that the total for those invoices were already included in the gross income you reported to the IRS anyway, so it can be a little less beneficial to your tax situation as other losses you may be able to write off. If you use the cash method of accounting rather than the accrual method, you won't have reported those unpaid invoices as income and therefore won't be able to write them off. The IRS maintains Publication 535 to explain writing off bad debts.

Looking Beyond Your Business for Tax Decisions

When calculating a tax return, Martin James, CPA looks at more than just the business's taxes. Family and retirement planning can be big considerations when it comes to deciding just what approach will be the best for an individual small business:

As a CPA for many small business clients, when it comes to losses and how we handle them, a client's business entity and family dynamics determine how we handle the losses. Many times, especially if it is a sole proprietor or partnership, we will attempt to preserve some deductions such as depreciation for future years due to the potential savings in self-employment taxes. The ideal situation would to be able to zero out the income through depreciation elections and save deductions that can be used against self-employment income in the future. The downside to that planning is that the small business owner is paying less into Social Security. However, if refundable credits are coming in to play, then we attempt to maximize those refundable credits if it makes sense. Additionally, business losses can provide an opportunity to do a Roth conversion or make Roth contributions. A little planning before the tax return is completed goes a long way. Our experience is that small business owners rely on professional advice to make the most lemonade out of the lemons.

Get Expert Help with Your Taxes

Claiming losses on your taxes can be a tricky proposition, making it especially important to bring in a pro early in the process to help you make sure that you're handling every step correctly. It's important to work with a tax professional on any business matters, but it's doubly important when it comes to deducting losses.

Eva Rosenberg of TaxMama has had clients who thought that claiming losses would be a lot easier than it actually is.

One of the saddest stories about small business losses is the fellow who came into my office sometime in early March, with a nice, neat set of QuickBooks financial reports — Balance Sheet (BS) and Profit and Loss Statement (P&L) — proudly showing me his $20,000 loss in the first year. He was confident that he'd done a good job with his books — and that he didn't owe a dime in taxes, other than the annual minimum S Corporation tax...I really, really hated to burst his bubble. Once I moved his asset purchases (leasehold improvements, store fixtures, etc.) off the P&L, made a journal entry to record the value of his year-end inventory, and corrected a few other little things — instead of a $20,000 loss, he had a profit of $100,000! Naturally, not being prepared for it, he had not paid any estimated taxes — either corporate or personal — and was hit with a very, very large tax bill (on the corporate level, as well as personally for IRS and state). Not all losses are as they appear to be.