Business losses: when you can deduct them against other income

A first-year business loss can reduce the tax on a salary or other income, which is a real benefit for new owners. But several limits apply, in a set order, and losses from hobbies are not deductible at all. This guide walks through them.

By Muhammad Bilal, Chartered Accountant. Reviewed by Awais Jameel, Chartered Accountant. Checked against official sources on . 3 minute read.

Short answer

Often, yes. A loss from a sole proprietorship, partnership, S corporation or LLC can generally offset wages and other income after passing four tests in order: enough basis, enough amount at risk, the passive activity rules, and a yearly cap on very large losses called the excess business loss rule. Unused losses carry forward to later years.

At a glance

Test 1
Basis in the business
Test 2
Amount at risk
Test 3
Passive activity rules
Test 4
Excess business loss cap
Left over
Net operating loss, carried forward
Hobby losses
Not deductible
Business losses: when you can deduct them against other incomeSteps: 1. Basis; 2. At-risk; 3. Passive activity; 4. Excess business loss.THE PROCESS AT A GLANCEBusiness losses: when you can deduct them againstother income1BasisFor partners and Scorporation shareholders,losses are limited to theirbasis: what they put in, plusincome left in, plus certaindebt2At-riskLosses are limited to theamount you could actuallylose, generally excludingnon-recourse debt3Passive activityIf you do not materiallyparticipate, losses canoffset only passive income4Excess business lossTotal business losses above ayearly inflation-adjustedamount cannot offsetnon-business income that yearChecked against official sourcesTax BakersBusiness losses: when you can deduct them against other incomeSteps: 1. Basis; 2. At-risk; 3. Passive activity; 4. Excess business loss.THE PROCESS AT A GLANCEBusiness losses: when you candeduct them against other income1BasisFor partners and S corporation shareholders,losses are limited to their basis: what theyput in, plus income left in2At-riskLosses are limited to the amount you couldactually lose, generally excludingnon-recourse debt3Passive activityIf you do not materially participate, lossescan offset only passive income4Excess business lossTotal business losses above a yearlyinflation-adjusted amount cannot offsetnon-business income that yearChecked against official sourcesTax Bakers
The process at a glance: 1. Basis; 2. At-risk; 3. Passive activity; 4. Excess business loss.

In what order are the limits applied?

  1. Basis

    For partners and S corporation shareholders, losses are limited to their basis: what they put in, plus income left in, plus certain debt.

  2. At-risk

    Losses are limited to the amount you could actually lose, generally excluding non-recourse debt. Form 6198.

  3. Passive activity

    If you do not materially participate, losses can offset only passive income. Form 8582.

  4. Excess business loss

    Total business losses above a yearly inflation-adjusted amount cannot offset non-business income that year.

How does it work for each business type?

BusinessWhere the loss goesMain limit
Sole proprietor or single-member LLCSchedule C, against other incomeAt-risk, passive, excess business loss
Partnership or multi-member LLCPartner's K-1 sharePartner's basis, then the others
S corporationShareholder's K-1 shareStock and loan basis, then the others
C corporationStays in the corporationCannot offset owners' income

What is material participation?

Being involved in the operations on a regular, continuous and substantial basis. One common test is working more than 500 hours in the activity in the year. Owners who run their own business usually materially participate, so their losses are not passive.

Other tests include being the only person who works in the activity, or working more than 100 hours and more than anyone else. Keep a simple log of hours, especially for side businesses, rental activities and businesses you co-own.

What happens to losses you cannot use?

Losses blocked by basis, at-risk or passive rules carry forward until the limit is cleared. A loss that exceeds your income for the year becomes a net operating loss, carried forward indefinitely and generally usable against up to 80% of taxable income in a later year. Most businesses cannot carry losses back.

What does an example look like?

A software engineer earns $150,000 in salary and starts a side business that loses $20,000 in its first year, all funded from her own savings and in which she works more than 500 hours. She has enough basis and amount at risk, the activity is not passive, and the loss is well under the excess business loss cap. The $20,000 reduces her taxable income to $130,000 before other deductions.

How do you claim the loss?

A sole proprietor's loss flows from Schedule C to Form 1040, with Form 6198 if the at-risk rules limit it, Form 8582 for passive losses, and Form 461 if the excess business loss cap applies. A partner or S corporation shareholder reports their share from Schedule K-1. S corporation shareholders claiming a loss must attach Form 7203 showing their stock and loan basis. Keep basis records every year, not just in loss years, because they are built up over time from contributions, income and distributions.

What about first-year losses?

Start-up costs before the business opens are not part of the first year's ordinary loss; they follow the start-up cost rules, with up to $5,000 deducted and the rest amortized. See start-up and organizational costs.

What if the IRS says it is a hobby?

Then the expenses are not deductible at all, while any income is still taxable. See hobby or business.

Do these rules apply to non-residents?

Only for losses connected with a US business. A foreign owner of a disregarded LLC without effectively connected income has no US return on which to claim a loss. See foreign LLC owner's personal US return.

Made a loss this year?

We check each limit, claim every loss you are entitled to, and track carryforwards so none are lost.

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Questions people ask

Can I deduct business losses against my salary?

Often yes, if you have enough basis and amount at risk, materially participate, and the loss is within the excess business loss cap.

What happens if my business loss is more than my income?

The excess becomes a net operating loss, carried forward and generally usable against up to 80% of taxable income in later years.

Can a C corporation's loss reduce my personal taxes?

No. A C corporation's losses stay in the corporation.

Can I deduct losses from a hobby?

No. Hobby expenses are not deductible, though hobby income is taxable.

Sources

Every fee, date and rule on this page was taken from these official and primary sources.

  1. IRS Publication 925: Passive Activity and At-Risk Rules
  2. IRS Publication 536: Net Operating Losses for Individuals, Estates, and Trusts
  3. IRS: About Form 461, Limitation on Business Losses

Rules and fees change. If you are reading this long after October 1, 2026, confirm the figures with the source before you rely on them.

Federal tax formsSchedule C (Form 1040): reporting business incomeFreelancers and self-employedTaxes on a side business when you also have a W-2 jobBusiness tax by entity typeHobby or business: how the IRS decides

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This guide is general information. It is not tax or legal advice for your situation.