Business Tax Preparation · Business Income

Net income, net operating losses, and loss limitations

A business loss must survive four separate limitations before it reduces taxable income, and they apply in a fixed order. Each has its own carryover rule, and a loss stopped by one of them is not the same animal as a loss stopped by another. Getting the order right is most of the work.

The rule

First, basis. A partner’s distributive share of loss is allowed only to the extent of the adjusted basis of their interest (IRC § 704(d)), and a shareholder’s is limited by the aggregate losses and deductions taken into account for any taxable year cannot exceed the sum of the adjusted basis of the shareholder's stock and the adjusted basis of any indebtedness of the corporation to the shareholder^TY2026 (IRC § 1366(d)(1)). A sole proprietor has no separate basis limitation.

Second, amount at risk. an individual, and a C corporation meeting the stock ownership requirement of IRC § 542(a)(2) — a loss from an activity is allowed only to the extent of the aggregate amount at risk for that activity at the close of the taxable year^TY2026 (IRC § 465(a)(1)). What counts is the money and the adjusted basis of other property contributed to the activity, plus amounts borrowed for use in it to the extent the taxpayer is personally liable for repayment or has pledged property not used in the activity, to the extent of the net fair market value of that pledged interest^TY2026 (IRC § 465(b)(1), (b)(2)), and except as regulations provide, an amount borrowed from a person with an interest in the activity, or from a person related to such a person other than the taxpayer, is not at risk^TY2026 (IRC § 465(b)(3)(A)). a loss not allowed for want of amount at risk is treated as a deduction allocable to that activity in the first succeeding taxable year^TY2026 (IRC § 465(a)(2)).

Third, passive activity. any individual, estate or trust, any closely held C corporation, and any personal service corporation — for these, neither the passive activity loss nor the passive activity credit is allowed^TY2026 (IRC § 469(a)). any activity which involves the conduct of a trade or business and in which the taxpayer does not materially participate; a rental activity is a passive activity whether or not the taxpayer materially participates^TY2026 (IRC § 469(c)(1), (c)(2)), and the taxpayer is treated as materially participating only if involved in the operations of the activity on a basis which is regular, continuous and substantial^TY2026 (IRC § 469(h)(1)). a loss or credit disallowed as passive is treated as a deduction or credit allocable to that activity in the next taxable year^TY2026 (IRC § 469(b)).

Fourth, excess business loss. the excess of the taxpayer's aggregate trade or business deductions for the year, determined without regard to the limitation itself and without regard to any IRC § 172 or § 199A deduction, over the sum of aggregate trade or business gross income and gain plus the threshold amount — computed without regard to any item attributable to the trade or business of performing services as an employee^TY2026 (IRC § 461(l)(3)(A)), where the threshold is $256,000, or $512,000 on a joint return — the IRC § 461(l)(3)(A)(ii)(II) amount for taxable years beginning in 2026^TY2026 (Rev. Proc. 2025-32 § 3.31). for a partnership or S corporation the limitation is applied at the partner or shareholder level, each taking into account their allocable share of the entity's trade or business items for the entity year ending with or within their own^TY2026 (IRC § 461(l)(4)), and a loss disallowed as an excess business loss is treated as a net operating loss for the taxable year for the purpose of determining any IRC § 172(b) carryover to subsequent years^TY2026 (IRC § 461(l)(2)).

What survives becomes a net operating loss. a net operating loss arising in a taxable year beginning after 31 December 2017 is carried forward to each taxable year following the year of the loss, without limit; one arising before that date was carried to each of the 20 following years^TY2026 (IRC § 172(b)(1)(A)(ii)), used subject to 80 percent — for a taxable year beginning after 31 December 2020 the deduction for losses arising after 2017 is capped at 80 percent of taxable income computed without the IRC § 172, § 199A and § 250 deductions; losses arising before 2018 are deducted first and are not capped^TY2026 (IRC § 172(a)(2)).

Current figures

How it works in practice

The order is not a convention; it is built into the statutes. IRC § 465(a)(1) limits “any loss from such activity,” presupposing a loss already allowed by the entity rules. IRC § 461(l)(3)(A)(i) aggregates trade or business deductions “determined without regard to whether or not such deductions are disallowed for such taxable year under paragraph (1)” — without regard to the excess business loss limitation itself, but after the earlier screens have done their work. Basis, at risk, passive, excess business loss.

Each stop has its own carryover, and they behave differently. A basis-limited loss waits for basis. An at-risk loss becomes a loss not allowed for want of amount at risk is treated as a deduction allocable to that activity in the first succeeding taxable year^TY2026 (IRC § 465(a)(2)) — allocable to that activity next year, so it waits for at-risk amount in the same activity. A passive loss is a loss or credit disallowed as passive is treated as a deduction or credit allocable to that activity in the next taxable year^TY2026 (IRC § 469(b)) — it waits for passive income, or for the disposition of the activity. An excess business loss does something different in kind: a loss disallowed as an excess business loss is treated as a net operating loss for the taxable year for the purpose of determining any IRC § 172(b) carryover to subsequent years^TY2026 (IRC § 461(l)(2)). It is converted into a net operating loss and joins the IRC § 172 pool, which means it is no longer tied to any activity but picks up the cap in IRC § 172(a)(2)(B)(ii).

At risk means personally on the hook. the money and the adjusted basis of other property contributed to the activity, plus amounts borrowed for use in it to the extent the taxpayer is personally liable for repayment or has pledged property not used in the activity, to the extent of the net fair market value of that pledged interest^TY2026 (IRC § 465(b)(1), (b)(2)). Non-recourse debt is not at risk, because the taxpayer is not personally liable and has pledged only property used in the activity. This is where the at-risk and basis rules part company for a partner: IRC § 752 gives a partner outside basis for a share of non-recourse liabilities, and IRC § 465 gives no at-risk amount for the same debt. A partner can therefore have basis and still be stopped.

Material participation is a facts test with a statutory floor. the taxpayer is treated as materially participating only if involved in the operations of the activity on a basis which is regular, continuous and substantial^TY2026 (IRC § 469(h)(1)) — regular, continuous and substantial. And note the sting in any activity which involves the conduct of a trade or business and in which the taxpayer does not materially participate; a rental activity is a passive activity whether or not the taxpayer materially participates^TY2026 (IRC § 469(c)(1), (c)(2)): a rental activity is passive whether or not the owner materially participates, so the participation question does not even arise for most rentals.

The excess business loss limitation is now permanent. permanent — Pub. L. 119-21 § 70601(a) struck the words "and before January 1, 2029," from both subparagraphs of IRC § 461(l)(1), so the limitation no longer has an expiry date^TY2026. It is also the one limitation that ignores the activity entirely: it aggregates every trade or business the taxpayer has, nets them, and disallows the amount by which the aggregate loss exceeds $256,000, or $512,000 on a joint return — the IRC § 461(l)(3)(A)(ii)(II) amount for taxable years beginning in 2026^TY2026. Two features catch people. deductions for losses from sales or exchanges of capital assets are left out of the deduction side, and capital gains counted on the income side are capped^TY2026 (IRC § 461(l)(3)(B)) keeps capital losses out of the deduction side. And wages are excluded entirely — the computation is made “without regard to any deductions, gross income, or gains attributable to any trade or business of performing services as an employee,” so a large salary does not absorb a business loss at this stage.

Then IRC § 172 governs what is left. a net operating loss arising in a taxable year beginning after 31 December 2017 is carried forward to each taxable year following the year of the loss, without limit; one arising before that date was carried to each of the 20 following years^TY2026 (IRC § 172(b)(1)(A)(ii)) — no expiry, and no carryback for most losses. 80 percent — for a taxable year beginning after 31 December 2020 the deduction for losses arising after 2017 is capped at 80 percent of taxable income computed without the IRC § 172, § 199A and § 250 deductions; losses arising before 2018 are deducted first and are not capped^TY2026 (IRC § 172(a)(2)). Pre-2018 losses are used first and are uncapped, so a taxpayer with both vintages must track them separately. The only general carryback left is a farming loss is carried back to each of the 2 taxable years preceding the year of the loss^TY2026 (IRC § 172(b)(1)(B)(i)).

How this has changed

IRC § 461(l) is permanent, and the published text does not say so. permanent — Pub. L. 119-21 § 70601(a) struck the words "and before January 1, 2029," from both subparagraphs of IRC § 461(l)(1), so the limitation no longer has an expiry date^TY2026. The section was enacted by Pub. L. 115-97 with an end date of 1 January 2026; Pub. L. 117-2 moved it to 2027; Pub. L. 117-169 moved it to 2029; and Pub. L. 119-21 § 70601(a) struck the phrase from both subparagraphs of IRC § 461(l)(1) altogether. The rendered statutory text at law.cornell.edu still shows “before January 1, 2027” — two amendments behind — while the amendment notes on the same page record all three changes. Where a rendered body and its amendment notes disagree, the notes are the reliable record.

The threshold is indexed from 2026, on a new base year. Pub. L. 119-21 § 70601(b)(1) substituted 31 December 2025 for 31 December 2018 in the opening words of IRC § 461(l)(3)(C), and § 70601(b)(2) substituted 2024 for 2017 in the cost-of-living clause. So the indexing restarts: the statutory figure in IRC § 461(l)(3)(A)(ii)(II) is adjusted for the first time for taxable years beginning in 2026, measured from a 2024 base. The 2026 amount is $256,000, or $512,000 on a joint return — the IRC § 461(l)(3)(A)(ii)(II) amount for taxable years beginning in 2026^TY2026.

The net operating loss rules have been through three regimes since 2017. Losses from years beginning before 2018 carry forward 20 years with no percentage cap. Losses arising in 2018, 2019 and 2020 were given a five-year carryback and freed from the cap by Pub. L. 116-136 § 2303, a relief that has now run out. Losses from years beginning after 2020 carry forward indefinitely, have no general carryback, and are capped: 80 percent — for a taxable year beginning after 31 December 2020 the deduction for losses arising after 2017 is capped at 80 percent of taxable income computed without the IRC § 172, § 199A and § 250 deductions; losses arising before 2018 are deducted first and are not capped^TY2026. A taxpayer with losses from more than one of those periods must apply them in the order IRC § 172(a)(2) sets, oldest vintage first and outside the cap.

Exam focus

Learn the order and be able to say why each limitation comes where it does. Almost every question in this area gives facts that trip one specific limitation, and the distractors are the answers you would reach by applying a different one.

Learn the carryover attached to each stop. Basis waits for basis; at-risk waits for at-risk amount in the same activity; passive waits for passive income or disposition; excess business loss becomes a net operating loss. The last is the one candidates most often state wrongly.

Know the two facts about IRC § 461(l) that changed in 2025: it is permanent, and its threshold is indexed for the first time in 2026.

For IRC § 172, know that the indefinite carryforward and the percentage cap arrived together and apply to the same losses, that pre-2018 losses are used first and are uncapped, and that the farming carryback is the survivor.

Check yourself

1. A sole proprietor has a $700,000 loss from her single business and $60,000 of interest income. She is single, fully at risk, and materially participates. How much of the loss is allowed?

Answer: $256,000. $256,000, or $512,000 on a joint return — the IRC § 461(l)(3)(A)(ii)(II) amount for taxable years beginning in 2026^TY2026 — the threshold for a single filer in 2026. The interest income is not trade or business income, so it does not enter the IRC § 461(l)(3)(A)(ii) side. The disallowed $444,000 becomes a net operating loss under IRC § 461(l)(2).

2. A partner has $95,000 of outside basis, of which $60,000 is his share of non-recourse partnership debt, and a $90,000 share of loss. How much is allowed before the passive rules are considered?

Answer: $35,000. IRC § 704(d) allows the loss to the extent of the $95,000 basis, but IRC § 465(a)(1) then limits it to the amount at risk, and the money and the adjusted basis of other property contributed to the activity, plus amounts borrowed for use in it to the extent the taxpayer is personally liable for repayment or has pledged property not used in the activity, to the extent of the net fair market value of that pledged interest^TY2026 excludes non-recourse debt for which he is not personally liable. The other $55,000 is suspended under IRC § 465(a)(2) and stays with the activity.

3. A taxpayer works 1,200 hours a year managing rental houses she owns. She has a $30,000 rental loss and $150,000 of wages. Is the loss deductible?

Answer: Not on these facts. any activity which involves the conduct of a trade or business and in which the taxpayer does not materially participate; a rental activity is a passive activity whether or not the taxpayer materially participates^TY2026 — a rental activity is passive whether or not the taxpayer materially participates, so the hours do not answer the question. The loss is suspended under IRC § 469(a) and carried forward under IRC § 469(b) unless a separate provision, such as the real estate professional rules or the active participation allowance, applies.

4. A corporation has a $2,000,000 net operating loss from 2027 and taxable income of $1,500,000 in 2028 before the deduction. How much may it deduct?

Answer: $1,200,000. 80 percent — for a taxable year beginning after 31 December 2020 the deduction for losses arising after 2017 is capped at 80 percent of taxable income computed without the IRC § 172, § 199A and § 250 deductions; losses arising before 2018 are deducted first and are not capped^TY2026 — the loss arose after 2017, so the deduction is capped by reference to taxable income computed without the IRC § 172, § 199A and § 250 deductions. The remaining $800,000 carries forward indefinitely under a net operating loss arising in a taxable year beginning after 31 December 2017 is carried forward to each taxable year following the year of the loss, without limit; one arising before that date was carried to each of the 20 following years^TY2026.

5. Why is an excess business loss carryover treated differently from an at-risk carryover?

Answer: Because a loss disallowed as an excess business loss is treated as a net operating loss for the taxable year for the purpose of determining any IRC § 172(b) carryover to subsequent years^TY2026 converts it into a net operating loss, so it leaves the activity and enters the IRC § 172 pool, where it is available against any income but subject to the cap in IRC § 172(a)(2). a loss not allowed for want of amount at risk is treated as a deduction allocable to that activity in the first succeeding taxable year^TY2026 keeps an at-risk loss tied to the activity that generated it, where it waits for the taxpayer to put more at risk.