Using Business Losses Against Your Taxes

Posted on Tuesday, December 16, 2008 at 8:09AM by

Jeff |

Matthew submits this question that deals with taxes. I am no tax professional, so I can only speak to what my understanding is based on years of paying someone else to figure this stuff out for me, and doing my best to follow along. Taxes can get unbelievably complicated, and I would advice you to hire a tax professional when it comes time to file your taxes. Please take everything I saw with a big grain of salt, as I make no claim to know what I'm talking about. At best, this should give you a few talking points with which to engage a real tax professional or CPA.

Matthew writes:

So I too am taking the plunge into a software startup. My question is regarding expenses and operating at a loss. How long can a corporation operate at a loss (and the founders use those NOL's against their own taxes due to the pass thru) before the government says, "sorry, you are taking to long to earn a profit". - and then i don't know what they can do from there but maybe they would shut you down or make you repay them for back taxes

You asked about corporate losses, and then referred to the ownership passthru. From this, I assume then that you are talking about an S-Corp or an LLC, as a C-Corp offers no such passthru. A C-Corp accumulates losses and then uses them against future earnings. If you look at the SEC filings for almost any software or high tech company, you'll see that (unless they've been in business for a great many years already), they are often carrying an accumulated loss on the balance sheet from all the investment capital they burned through getting to where they are today.

In an LLC or an S-Corp, profits and losses are passed through to the owners, as you describe. There is no hard limit as to when the IRS decides that they've had enough of your losses. The real test, as it's been described to me, is whether or not you are running the LLC/S-Corp as a legitimate business and not as some kind of loss-maker for taxes or just as a hobby. I've been told that you'll get a few years of losses without raising any red flags, but by the third year some additional activity should be expected.

What does "additonal activity" mean? I have no idea. I don't know if the IRS agents review these things by hand, or if a computer algorithm spits out the red flags, or what - but I assume that by year three you should either be showing some profit, or at least the revenue and expense numbers you submit to the IRS are increasing, or you have employees with W-2s, or you have sales taxes paid, or you have inventories, or something. Like I said, I don't know exactly, but there is no shortage of financial information that local, state, and federal officials demand on a regular basis, so there should be plenty of data to cross reference.

However, if you are keeping good records, properly file all your paperwork, and running a legitimate business, then in theory there is no limit to how long you can accumulate those losses -- other than, you know, no one wants to run a business forever that fails to do anything but drain the bank account. :)

You should also be aware that the way the IRS wants you to account for things on your taxes does not always follow real cash flow (or for that matter, logic). For example, if you start a business, you probably have some sort of legal fees from the incorporation process, either from attorneys you paid or from a do-it-yourself incorporation service, like LegalZoom. For easy math, lets say you spent $5,000 in startup legal expenses, and that in the first year you provided $4,000 worth of consulting services, and incurred no additional expenses.

$4,000 - $5,000 = a $1,000 loss for the year, right?

Wrong. (and who says 1+1 always = 2?)

The IRS says you can not take all of your startup expenses in the first year, which is logic than only the US Congress can follow. You have to amortize those expenses over several years, generally 5. So:

$4,000 income - ($5,000 / 5) legal expenses = $3,000 profit (and $4,000 in startup expenses you'll carry on your balance sheet to use over the next 4 years).

So now you owe taxes on $3,000 of "income" even though your bank account is $1,000 in the hole. Congratulations. If you can scrape together enough money for a stamp, write to your Congressman as ask them what kind of buffoon concocted a scheme by which you would owe taxes on money you don't actually have.

There are a number of exceptions and elections that you can take that will change how this gets calculated. You'll want to hire a tax accountant to help you with all this. At least you can rest assured knowing that the expense of having that accountant will be tax deductable... at least until congress decides that it isn't.

And you wonder why the tax code is over 16,000 pages long and spans 20+ volumes on a bookshelf. Suffice it to say that 1+1 = 2, in general, but that the government has managed to come up with some 16,000 pages of exceptions to that rule. Enjoy.

In fact, you can order a nice bound set of these 20 books from the government for $974. But don't ask me if it's tax deductable or not, it's probably covered somewhere in those books. Maybe.

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