How to Get a Tax Benefit from Business Losses

If you are a new startup, you may realize a small profit at the end of the year, buton paperyou report a loss. Reporting a loss on paper is common for some new startups during the first two or three years. Thisis especially true when someone is turning a hobby into a profitable business venture. Depending on the type of business entity you choose after speaking with a Maryland business attorney, you could benefit from those losses while you are building and growing your business. 

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Sole Proprietorships and Single-Member LLCs

If you remain a sole proprietorship or you organize your company as a single-member LLC, the profits and losses of your business are “passed through” the business to you. In other words, the income and losses of the business are reported on your personal income tax return. Owners report the income and expenses from the business on Schedule C to determine the net profit for the business. Sometimes, when you deduct all allowable expenses for the business from the business income, you may have a net loss. 

If your business had a net loss, you must take an additional step to determine if your investment in the business was “at risk” under IRS guidelines. Most owners of a small business have at risk investments in the business. If your entire investment in the business was at risk, you should be able to deduct the entire business loss. Deducting the business loss could substantially lower your taxable income for the year.

An important distinguishing factor is the loss from “passive activity.” If you are not actively involved in the business, you may not be able to deduct the loss. You may only deduct losses up to the amount of income generated by the business if not actively involved in the business. 

Partnerships and Multi-Member LLCs

Partnerships and multi-member LLCs are also pass-through entities for tax purposes. However, reporting income and losses from this type of pass-through entity differs from a sole proprietorship or a single - member LLC.

A partnership or multi-member LLC must file an informational tax return. The business does not pay income tax, but it must file the return to report business income and losses to its owners. As part of the business tax return, the company issues a K-1 Form to each owner. 

The K-1 Form reports the business income or loss allocated to each owner based on the owner’s operating agreement. The owner uses the information on the K-1 Form to complete his or her personal income tax return. The profit or loss is typically reported on Schedule E of the owner’s personal income tax return. Sometimes, a loss could reduce overall taxable income. However, the losses could be limited depending on the owner’s tax information.

Seeking Advice from a Maryland Business Attorney

Tax law is extremely complex. The above information is only a general overview of a small portion of the tax information a business owner considers when choosinga business entity for his or her company. For instance, it does not cover other topics such as self-employment tax or carrying over net losses from previous years.

Your choice of a business entity has a significant impact on future tax requirements and obligations. Schedule a consult with Maryland business attorney Stephen Thienel today to discuss how a business entity choice impacts tax issues. Mr. Thienel has decades of experience assisting clients with their business and tax planning needs throughout, Maryland, Virginia, and the District of Columbia.