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Tax Tip: Losses

Posted: June 19, 2012, 4:30 p.m. EDT

By Mark E. Battersby

Whether the result of the economy, competition or events outside the control of a business owner, losses are almost inevitable. While no one plans for a loss, many smart retailers, manufacturers and distributors do, however, plan to minimize the effect of losses, reverse them more quickly and, in some cases, reap the benefits of increased cash flow, lower tax bills and refunds of previously paid taxes.

Planning to ensure preferential tax treatment—and a lower tax bill—for losses can begin at the beginning, or more likely early in a pet business’ operations. To give the owners of small incorporated businesses the same deduction advantages as the owners of unincorporated businesses, Congress created Section 1244 of the tax law. Under Section 1244, the owners of certain corporations may be entitled to take ordinary loss deductions following the sale or liquidation of their businesses.

Business losses
Although Section 1244 applies to all incorporated businesses, owners of S corporations also have other ways to deduct losses. Because Section 1244 only gives relief to the original owners of the corporation, if stock in the corporation was from someone else, they are not eligible for Section 1244 relief.

Another loss, the net operating loss (NOL), occurs when a business’ deductions are more than its income. Currently, NOLs can be carried back two years, often producing refunds of taxes paid in those earlier, more profitable years. If two years ago the business was not profitable enough to negate this year’s NOL, the potential deduction may be carried forward up to 20 years until used up. Forgoing the carryback period could be beneficial if the operation’s marginal tax rate in the carryback years was unusually low.

A number of unfortunate business owners—particularly those whose businesses operate as a pass-through entity such as partnerships, S corporations or limited liability corporations—have discovered that there can be such a thing as too much loss. Under the tax rules, a partner or S corporation shareholder cannot take a loss in excess of the amount invested in the business.
For S corporations, a shareholder’s “basis” includes equity investments as well as direct loans. That basis is increased by profits and reduced by losses and distributions, but once the basis is reduced to zero, additional losses are suspended.

Inventory losses, casualty and theft losses (to the extent not covered by insurance), and losses on the sale of business assets may also be deductible. Casualty losses, at least if they are the result of a legitimately declared “disaster,” can be used to recoup taxes paid in the previous tax year.

Would a refund on taxes paid by the formerly profitable business in years past help ease the pain of lingering losses this year? What if last year’s business losses could offset next year’s profits and reduce the tax bill for years to come? All this, and more, is possible with loss planning.


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