April 21, 2021
Losing a business is always difficult, and during the global COVID-19 pandemic of 2020 and 2021, many small business owners were forced to close due to quarantine restrictions. Although some of those businesses pulled through the economic downturn, many were overwhelmed by the plunging economy and were unable to sustain themselves.
Now that tax season has arrived, it is only natural to need to convey to the IRS that you have lost your business and been without your primary source of income for a substantial amount of time. Filing taxes is already a complicated procedure, so here are five tips to keep in mind if your business was one of the unfortunate many that didn’t survive the pandemic.
Tip 1: It Must Qualify as a Business, Not a Hobby
One of the most essential parts of filing your taxes is being able to prove that your source of income is a business and not a hobby. If you can do so, expenses for materials, employees, and other types of costs can be deducted from your taxes. Businesses are typically classified as hobbies when the owner has another source of income, such as a part-time or full-time job or a working spouse.
However, if you can prove to the IRS that your business is your sole means of income or at least the primary source, you can deduct business-associated costs from your total income and lower the taxes you need to pay. The IRS carefully considers the financial information about your business to decide whether it qualifies you to take deductions or if it is a hobby.
Since the Tax Cuts and Jobs Act passed in 2018, you are not allowed to deduct any costs for hobbies on your taxes. This Act will expire in 2025 unless renewed, but as it stands, your hobbies cannot affect your taxes. In order to take advantage of your business, you must prove that it was for-profit, even if you ended up losing a lot of money through it.
Basically, you would need to show a tax auditor evidence that your business was legitimate which might include:
- Licenses or certificates obtained to run the business
- A separate business bank account
- A website promoting your business
- Evidence of paid advertisements or promotions for your business
- Records of salaries or wages paid to employees
- Substantial assets purchased (this mostly applies to freelancers who work in construction or other manual labor professions)
Once you have proven that your business was for-profit and should not be classified as a hobby, you can deduct expenses and losses from your business against your taxable income. As we discuss in the next section, net operating losses can be deducted from your overall income, even if you are filing jointly with your working spouse.
Tip 2: Understand NOL
NOL, or net operating loss, means that your business incurred more expenses than profit. It doesn’t only apply to small businesses either. NOL is a significant factor for businesses of all sizes, especially during an economic downturn such as the one experienced during 2020. Figuring out how to deduct your NOL on your taxes is where things can get more complicated.
For someone who is the sole owner of their business, the NOL can be deducted from their personal tax statement, assuming that they have adequate proof that the business is for-profit and not a hobby. However, if you have a partner or multiple partners, the NOL must be divided amongst the group, meaning that you can only deduct a portion of the NOL on your personal taxes.
The exception to this rule is if you are the owner of a C corporation, in which case shareholders may not deduct any business losses on their individual taxes because the corporation already deducts the entire amount.
In previous years, depending on the size of the NOL, business owners could apply for a refund for taxes paid prior to the current tax year to offset the operating loss of the current year. However, the Tax Cuts and Jobs Act passed in 2018 forbid that and set a limit on how much of the NOL could be applied to the current year. Specifically, you can only deduct up to 80% of your taxable income through your business’s NOL.
For some businesses, the losses incurred by a business folding can well exceed their taxable income for that year, especially if their business was their sole source of income. However, the Act did not stop people from carrying those losses forward, as we clarify in the following section.
Tip 3: Learn About Carry Forward
While you can’t always deduct the full amount of your NOL from the current tax year’s income, there is no limitation on how many years you can carry forward that loss. For example, if you have an NOL of one million dollars for the tax year 2020, you would only be able to put some of that NOL against your income as a deduction.
However, when the time comes next year for you to file your 2021 taxes, under the Tax Cuts and Jobs Act, you can continue to use some or all of the amount leftover in your NOL to offset up to 80% of your gains or income for 2021. As long as you incur or have remaining losses, you can continue to use them to offset your income for many years.
Prior to 2018, business owners were also able to file for a tax refund from the IRS if their NOL exceeded their income for the tax year. This was known as carry-back and allowed businesses to see an immediate recovery if they had paid substantial taxes in the previous years and needed that money to offset part of the loss they experienced. However, the Tax Cuts and Jobs Act ended that practice and only allows business owners to carry losses forward from now on.
Previously, there was a cap of 20 years, meaning that you could only carry forward a loss for two decades before you were forced to reconcile the lost money and move forward with a clean slate. However, the Tax Cuts and Jobs Act amended that, and you can now carry forward losses as long as they exist.
This is intended to be beneficial for ongoing companies who incur substantial amounts of losses and is unlikely to affect a small business or a business that went under. Currently, the CARES Act has enabled business owners to not only carry losses forward but also to carry those losses back for tax refunds paid in previous years.
As we discuss next, the CARES Act was passed to offer immediate economic relief during the Coronavirus pandemic since so many small and medium-sized businesses were dramatically affected by the enforced shutdown.
Tip 4: The CARES Act
As a result of the global pandemic, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (or CARES Act) in 2020. This Act temporarily suspended the restrictions introduced in the Tax Cuts and Jobs Act of 2018, allowing business owners to use their net operating losses to offset taxes paid in 2020, 2019, and 2018.
The CARES Act also allows business owners to exceed the 80% limit for deducting their NOL and lets them deduct up to 100% of their other taxable income. If your business incurred NOLs in the last two years that have not been accounted for yet, you could now use them to request a refund for any taxes you paid going back to 2016.
Another restriction of the Tax Cuts and Jobs Act that the CARES Act suspends is the upward limit on the amount of NOL that can be deducted. For married couples filing jointly, the maximum amount of NOL that can be deducted is $510,000 and $255,000 for single people. With the CARES Act, there is no limit to the NOL deduction.
Finally, the CARES Act added a clause to the Tax Cuts and Jobs Act that will be especially beneficial to restaurants, retail stores, and cafe owners. With the amendment, if you paid for any kind of interior remodeling or redecoration from 2018 and beyond, you can now deduct the expenses from your taxable income as well.
Keep in mind that the CARES Act will most likely be temporary and will end after the United States has rebounded from the current economic crisis. While you can currently file for a tax refund for taxes paid in the last few years if your loss of business generated enough to offset your previous years’ income, this will likely end in the next year or two, and the Tax Cuts and Jobs Act of 2018 will return to effect.
Tip 5: Know How Bankruptcy Plays a Role
If your business declared bankruptcy, the IRS would still require you to file your taxes like usual, but there are some special considerations. For example, if you owed the IRS money for back taxes, they may waive those taxes if you can prove that your business filed for bankruptcy and incurred a significant loss.
However, if the IRS had filed a lien against your business prior to declaring bankruptcy, there is a chance that they will not waive the lien. In that case, they will seize any business assets to offset the amount of the lien and will expect you to pay the rest of the lien. If your business does not have any assets, you will be expected to use your personal assets or money to compensate.
Contact Us Today
With everything else that is going on in 2021, it’s understandable that many people would rather file their taxes online or get in touch with an expert to assist. If you need help filing your taxes, reach out to Enterprise Consultant Group’s tax advisors. We can answer your questions, explain the process, and give you tangible solutions. Contact us online or at (800) 575-9284 today to schedule a free and confidential consultation to see how we can help you.
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