You don't have to be a corporation to use a net operating loss (NOL) to reduce your taxes. Individuals can use a business loss to offset business income for prior or future years. But can the loss from another business offset self-employment income?
Although a business loss, whether it is from a Schedule C business, a partnership, or S corporation, can be used to reduce business income on your personal return, it's not as simple as offsetting a loss from a prior year against the business income for the current year. And that's important when self-employment tax is involved.
For example, say you have a $60,000 profit from your sole proprietorship and a $35,000 loss carryforward from that business from a prior year. You can't net the two to end up with a $25,000 profit for the current year. If the income comes from a sole proprietorship or partnership, that means you'll have to pay self-employment tax of about 12.3.percent of $60,000 (2012 amount; we rounded for simplicity) or $7,380 on the profit, despite having a carryforward loss. If you could offset the profit and loss for self-employment tax purposes, you'd owe 12.3 percent on $25,000, or $3,075. The difference is $4,305. If your business alternates between profit and losses from one year to the other, the extra tax can quickly add up.
The first step is to determine if you have a net operating loss (NOL) for the year. Just because you have a loss on your Schedule C or a loss from your S corporation doesn't mean you have an NOL. You must net that loss against other business income or losses. Business income (or loss) or your personal return is usually generated by wages, rents, unemployment compensation, as well as partnership, Schedule C or S corporation income (or loss).
Thus, wages from a job could offset losses from a sole proprietorship or LLC, resulting in no NOL. Interest, dividends, pensions, Social Security, etc. represent nonbusiness income. Some income, such as capital gains, can fall into both categories, depending on the source of the income or loss.
Next, identify business and nonbusiness deductions. The self-employment tax deduction is a business deduction; the IRA deduction is a personal deduction. Medical deductions and interest expenses are personal deductions; some taxes may be personal, some business.
If you have a net business loss, you must compute the amount of your NOL using Schedule A of Form 1045. Start with your taxable loss from all sources, but make adjustments for nonbusiness income and nonbusiness deductions to arrive at your NOL.
Generally, you can carry back a loss to the earlier of two years. (Special rules apply to certain specific losses.) If the loss isn't completely utilized in the earliest year, it can be carried forward and used in the next year. If there is still an unused loss, it may be carried forward for 20 years. You can also make an election to forgo the carryback and just carry the loss forward. That often makes sense if you expect to be in a higher tax bracket in future years.
This can be a tricky area. The election to waive the carryback must be made by the due date of the return or on an amended return filed within six months of the unextended due date. In addition, the rules and computations may become complicated. If you are in this situation, seek professional assistance.