If you are reporting losses multiple years in a row you can face an increased risk of an IRS audit, especially if the losses being reported are offsetting substantial other income. The IRS expects a business will attempt to earn a profit. Your business activity is presumed to be for-profit if the business generated a profit in at least 3 out of the last 5 tax years. If this is not the case the IRS may reclassify your activity as a hobby instead of a for-profit entity. If the IRS does consider your business a hobby you are only able to deduct losses up to the amount of income earned in the activity.
Some factors the IRS considers are:
- Manner of operation. Do you maintain accurate books and records, have a business plan, and change methods to improve profitability?
- Time and effort. Do you put in enough time and effort to suggest a profit motive?
- Expertise. Do you or your advisers have the necessary knowledge to succeed?
- Profit history. Have you made a profit in similar activities in the past?
- Financial status. Do you have other sources of income to fund the activity?
- Personal pleasure. Is there an element of personal recreation in the activity?
TurboTax will automatically track losses and carry them forward to future tax years; however, it is your responsibility to maintain all required documentation in case you are audited.
- Net operating loss (NOL): Business deductions that exceed income can create a Net Operating Loss (NOL). An NOL can be carried forward indefinitely to offset up to 80% of your future taxable income.
- Excess business loss: For non-corporate taxpayers, there is a yearly limit on how much business loss can be used to offset non-business income. Any excess is treated as an NOL carryover.
- Passive activity losses: If your business is considered a passive activity—one in which you do not "materially participate"—passive losses can only offset passive income. Undeducted passive losses are carried forward indefinitely until you have passive income or dispose of the activity.
To manage multi-year business losses and prepare for a potential IRS audit:
- Keep excellent records. Maintain detailed and accurate records of all business income and expenses to demonstrate your profit motive.
- Create a business plan. A formal plan that shows how you are working to become profitable helps prove your intent to the IRS.
- Demonstrate a profit motive. Show evidence of marketing efforts, research, or operational changes made to improve profitability.
- Consult a tax professional. A professional can provide expert guidance on navigating complex rules, especially if you have significant income from other sources.
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