The bright side of business losses

No one goes into a business to lose money unless they are interested in committing tax fraud.   But even losses and bad debts can be used to survive until better times come around.

If you want to open a business but worry about financial losses, today’s post will show you potential ways to deal with them and stay afloat.

Using Net Operating Losses to Your Tax Advantage

A net operating loss occurs when a business’ allowable tax deductions exceed taxable income.

Businesses were once allowed to carry an NOL back through two years of taxable income somewhere in that period. This worked especially well if the company had turned a profit in at least one of those years.

Changes to the Tax Cuts and Jobs Act ended that carryback option for most businesses in 2018, but you can still bring an NOL forward indefinitely. That’s called a carryforward, and it can be so helpful it is listed as an asset on balance sheets.

But there is a catch. Actually, there are a couple of them.

First, NOL carryforwards are limited to 80% of each subsequent year’s net income. So, if your company had an NOL of $8 million one year and taxable income of $10 million the next, the carryover limit for that second year would be $8 million.

The remainder could be carried over into following years until the NOL dissipates.

But what if you have two NOLs in back-to-back years? That’s the other catch. You can’t stack NOLs. They have to be used one at a time.

Ideally, you’d never have to worry about an NOL, but they happen, and often, it’s at least partially because of bad debts. Fortunately, there is some tax relief for those, too.

Claiming bad debts

Unpaid invoices and loans are the bane of an entrepreneur’s existence. But they can be deducted from your business income.

That lowers taxable profit and provides some relief for losses.

You do have to prove to the IRS that appropriate steps have been taken to collect the debt. That doesn’t necessarily mean going to court. It just means proving the debt is not collectible.

For example, showing the IRS the creditor filed for bankruptcy might be enough.

In the case of a loan, you also have to prove that it was not a gift. So, even if you are only lending money to that nephew of yours, it pays to get the loan documented and notarized.

And if that nephew pays back part of the loan before defaulting, you can only claim the unpaid part.

Timing is important, as well. You don’t have to wait until the debt is due to claim it as uncollectible, but you do have to take the deduction in the year the loan became worthless.

The Bottom Line

NOLs and bad debts are hardly the stuff of entrepreneurial dreams, but they don’t have to be complete nightmares either.  Gleaning a better experience from these two problems isn’t always easy since tax laws can be complicated and dynamic. So, get educated, get some help from a trustworthy CPA, and be ready when economic storms come your way.