If your business runs at a net loss, you do not pay federal income tax on that business for the year, and the loss can often reduce the tax you owe on other income like wages or investment gains. That is the short answer to whether you pay taxes if your business makes a loss. The longer answer depends on your entity type, how the loss is characterized, and a stack of federal rules that can cap or delay the deduction. Some taxes, including certain state fees, can still apply even in a losing year.
How a Loss Reduces Tax on Your Other Income
A net loss happens when your allowable business expenses exceed your gross revenue. For a sole proprietor, the calculation lives on Schedule C, and the bottom-line number flows directly onto Form 1040.1Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship) Partnerships and S corporations pass the loss through to owners, who report their share on Schedule E; an S corporation allocates the loss by ownership percentage on Schedule K-1.2Internal Revenue Service. 2025 Shareholder’s Instructions for Schedule K-1 (Form 1120-S)
Combined with other income on your personal return, the loss shrinks your taxable base. If you earned $150,000 in wages and your business lost $40,000, your taxable income drops to $110,000. That is different from a tax credit: the loss reduces the income tax is calculated on, not the tax itself.
None of this works without records. The IRS expects receipts, bank statements, canceled checks, invoices, and mileage logs to back up every expense in the loss.3Internal Revenue Service. Burden of Proof Travel and vehicle expenses face tighter substantiation rules. Claim a large loss with nothing to show for it and an audit can disallow the deductions entirely, turning an expected refund into a bill.
Rules That Can Cap or Suspend the Deduction
Four federal limits can shrink the loss you actually get to use. They apply in order, and clearing one does not exempt you from the next.
The Hobby Loss Rule
Section 183 blocks loss deductions from activities the IRS treats as hobbies rather than businesses. If reclassified, your deductions are capped at the income the activity produced, so it can never generate a net loss to offset wages.4Office of the Law Revision Counsel. 26 U.S. Code 183 – Activities Not Engaged in for Profit The IRS generally presumes a real business if the activity turned a profit in three of the last five years (two of seven for horse activities). Otherwise it weighs factors like whether you run the activity in a businesslike manner, your expertise, time and effort, dependence on the income, and whether personal recreation is involved.5Internal Revenue Service. Is Your Hobby a For-Profit Endeavor A separate bank account, a written business plan, and course corrections when things aren’t working all help show a genuine profit motive.
At-Risk Rules
Even in a real business, you can only deduct losses up to the amount you have “at risk,” which generally includes cash and property you contributed plus money you borrowed and are personally liable for.6Internal Revenue Service. Publication 925 – Passive Activity and At-Risk Rules Nonrecourse loans generally don’t count. Lose $80,000 with $50,000 at risk, and $30,000 is suspended until you put more in.
Passive Activity Loss Rules
If you invest in a business but aren’t regularly, continuously, and substantially involved, your losses are passive and can only offset passive income, not wages, salaries, or portfolio income.7Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited Material participation has seven tests, and you only need one; the most common is logging more than 500 hours in the activity during the year.8Internal Revenue Service. Instructions for Form 8582 Suspended passive losses are released in full when you sell your entire interest in the activity in a taxable transaction.
The Excess Business Loss Cap
Section 461(l) then caps how much total business loss a noncorporate taxpayer can deduct in a single year. For 2025, the threshold is $313,000 for single filers and $626,000 for joint filers, adjusted for inflation.9Internal Revenue Service. Instructions for Form 461 – Limitation on Business Losses For 2026 the threshold drops to approximately $256,000 single and $512,000 joint following the One Big Beautiful Bill Act, which made the limitation permanent. Anything above the cap is an “excess business loss,” disallowed this year and treated as a net operating loss carryforward going into the next.10Internal Revenue Service. Excess Business Losses The calculation is reported on Form 461, attached to Form 1040.
What Happens to a Loss You Can’t Use This Year
When your allowed loss is larger than all your other income, the leftover portion becomes a net operating loss. Under current law the NOL carries forward indefinitely.11Office of the Law Revision Counsel. 26 U.S. Code 172 – Net Operating Loss Deduction There is no carryback for most taxpayers; losses generated after 2017 move forward only.
The catch: NOLs from tax years beginning after December 31, 2017, can offset only 80% of your taxable income in any future year. The remaining 20% stays taxable no matter how large your stored losses are. If next year you have $100,000 of taxable income and a $200,000 NOL available, you use $80,000 of the NOL, pay tax on $20,000, and carry $120,000 forward. Tracking the running balance is your job, not the IRS’s. A simple spreadsheet showing each year’s NOL, how much was used, and what remains keeps you from leaving money on the table.
How Your Entity Type Changes the Answer
Where a loss ends up depends on how the business is organized.
Sole proprietorships, partnerships, and S corporations are pass-through entities. Sole proprietors report the loss on Schedule C; partners and S corporation shareholders report their share on Schedule E.12Internal Revenue Service. About Schedule E (Form 1040), Supplemental Income and Loss Either way, the loss can offset wages and other personal income on the owner’s Form 1040, subject to the limits above.
Basis works differently between partnerships and S corporations, and it can decide how much loss you get to use. Partners get basis from their share of partnership debt, both recourse and nonrecourse. S corporation shareholders only get basis from stock they’ve bought and loans they personally made to the corporation; the company’s own borrowing doesn’t help. Losses beyond your basis are suspended until you invest more or the business earns enough to restore it.13Internal Revenue Service. 2025 Instructions for Schedule E (Form 1040) – Section: Part II
A C corporation is a separate taxable entity. Its losses stay at the corporate level and do not pass through to shareholders.14Internal Revenue Service. Forming a Corporation The corporation carries its own NOL forward under the same Section 172 rules and uses it against its own future profits. As a shareholder, you get no immediate personal tax benefit from a C corporation’s loss.
Taxes and Credits You Can Still Lose Out On
A loss year has some quieter costs. Self-employment tax funds Social Security and Medicare and is calculated on your net self-employment earnings. Net earnings of zero or below mean no SE tax, but they also mean no Social Security credits for that year. Credits are earned based on net self-employment earnings, and you need 40 over your working life to qualify for retirement benefits.15Social Security Administration. If You Are Self-Employed Several loss years in a row can leave a real gap in your record. The SSA’s “optional method” lets self-employed people earn credits in low or negative earnings years, but it can only be used five times in a lifetime for non-farm income, so it’s a strategic call rather than an annual one.
State taxes can survive a federal loss. Many states charge minimum annual taxes, franchise fees, or gross-receipts taxes on registered businesses regardless of profit. A net loss on your federal return does nothing to eliminate them. State NOL treatment also varies: some states track the federal 80% limit and indefinite carryforward, others impose annual dollar caps or shorter carryforward periods, and some have temporarily suspended NOL deductions during budget shortfalls. If you operate in more than one state, each applies its own rules to the portion of income or loss allocated there. Check your state’s conformity with federal NOL provisions each year, because these rules change more often than most other tax provisions.