Net Operating Loss for a Sole Proprietorship

By Jeff Franco J.D./M.A./M.B.A.

It isn’t uncommon for sole proprietors to report losses in some years, which are the result of incurring business expenses that exceed total revenue. You may be able to use these losses to offset some of the other income reported on your tax return. However, if after combining your sole proprietorship losses with your other income the result is still a loss, you may have a net operating loss, or NOL, that you can deduct from the taxable income you report in different tax years.

Sole Proprietor Losses

All sole proprietors report business earnings and losses to the IRS on a Schedule C or C-EZ attachment to their personal income tax returns. Schedule C is used to calculate your net business profit or loss, which is ultimately reported on your 1040 form and combined with income not related to the sole proprietorship. But when total business expenses reported on Schedule C exceed total revenue, the result is an NOL. And depending on the type and amount of other income and deductions reported on the 1040, you may be able to use the NOL to reduce the tax you owe.

Calculating NOLs

The net loss reported on Schedule C may not always equal the amount of NOL you can use to offset other income. When calculating an NOL, you must exclude the personal and dependent exemptions you claim, deductions for excess capital losses, excess of your non-business deductions over non-business income and a number of specific deductions, such as the domestic production activities deduction. In addition, you can never include a prior-year NOL when calculating an NOL for the current year. In other words, you’ll calculate the NOL as if your tax return didn’t include any of these prohibited tax items.

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Business and Non-Business

When calculating your NOL, it’s important to understand that the term “business” doesn’t only apply to your sole proprietor activities. The IRS treats any employment income reported on your 1040 as business income, in addition to amounts reported on Schedule C. Similarly, business deductions that can increase the amount of your NOL, which aren’t reported on Schedule C, include the educator expenses deduction, moving expenses that relate to a job or your business, and any itemized deduction that relates to your employment. Non-business deductions, however, cover the standard deduction, alimony payments and contributions you make to a tax-deferred retirement plan to name just a few.

Carrybacks and Carryforwards

If the NOL from your sole proprietorship is larger than the other taxable income you report, meaning you can’t use the NOL in the current year, you must generally carry the NOL back to offset income reported on the tax returns filed for the most recent two tax years, though some exceptions to this general rule exist. You start with the oldest year first, and if unable to use any or all of the NOL on that return, the excess is used on the more recent return. This allows you to obtain a refund for prior taxes paid, but you’ll need to file one Form 1045 for both years or amend each return using separate Forms 1040-X for each year. The unused balance of your NOL can then be carried forward to use on tax returns filed over the next 20 years.

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Deductible Expenses in a Sole Proprietorship

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