A sole proprietorship is one of the simplest business structures. You don't have to complete a separate tax return for the business; you simply figure your profit or loss and report the amount on your personal Form 1040. If you realize a loss on the business instead of a profit, in most cases you can use that loss to offset other income you earned during the year, reducing your total taxable income. You can even carry over a loss to affect your taxes in future years. The Internal Revenue Service has specific rules about when you can take a loss and how to report it.
Figuring Your Loss
As a sole proprietor, you complete a Schedule C, Profit or Loss From Business, and attach this to your 1040. On the Schedule C, you list all your income from the business for the year and deduct all your expenses. Typical business expenses include items such as supplies or materials, advertising, postage, depreciation of equipment you use in your business, office rental and anything you purchased that was necessary to run your business. When you deduct your total expenses from your business income, you end up with a figure that represents your profit or loss. You need a separate Schedule C for each business you operate.
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After you conclude you have a loss from your business for the year, answer the question on line 32 of Schedule C. This asks if all or part of your investment in the business is at risk. If all the money invested in the business belonged to you or to family members, or if you borrowed money to open the business, then all your investment is at risk. If you used money from an unrelated third party who gave you money in exchange for an interest in the business, then the investment is not all at risk. If the business failed, you wouldn't have to pay your investor back, he would simply lose the money as part of the risk of doing business. If all the money is not at risk, check line 32b and complete Form 6198 to determine what percentage of the business loss you can claim on your Form 1040.
Reporting Your Loss
Report your business loss on line 12 of Form 1040. Also report the loss on line 2 of Schedule SE. Use Schedule SE to figure how much Self-Employment tax, if any, that you owe. The loss you report on line 1040 is subtracted from your other income for the year, reducing your total taxable Income.
To deduct a business loss on your taxes, the IRS requires you to operate your business with the goal of making a profit. You can't have a business that shows a loss every year solely for the purpose of reducing your taxes. The IRS considers you to be operating a business for profit if you earn a profit in three out of five years. If you do not earn a profit in three out of five years, the IRS could disallow your loss deductions.
The IRS looks at other factors that point to operating a business for profit, even if you have more than two years of losses in a five-year period. These include conducting your business in a professional manner, devoting considerable time and resources to the business and demonstrating efforts to make the business profitable, you anticipate a future profit, you've made a profit with a similar business in the past, you have the knowledge necessary to make the business profitable, losses are ordinary in this type of business or during the start-up phase of the business, and you depend on the business for your livelihood.