Small business owners can generally use net operating losses (NOLs) to offset taxable income from another tax year. However, as shown in a new case, Root, TC Memo 2025-51, 5/22/25, simply intending to carry on a business won’t generate a tax-favored loss.
Background: Prior to the Tax Cuts and Jobs Act (TCJA) NOLs could be carried back two years to offset taxable income before being carried forward for up to 15 years. Under the TCJA, however, the two-year carryback period was repealed (except for certain farms and insurance companies). In other words, NOLs now can only be carried forward. However, the allowable carryforward period is indefinite instead of being limited to 15 years.
Significantly, the TCJA also limited an NOL to 80% of the firm’s taxable income, determined without respect to claiming the NOL There was no such limit on NOLs under prior law. Carryforwards must be adjusted to take the 80% limit into account.
The TCJA also limited losses of noncorporate taxpayers (e.g., individuals, estates and trusts) that may be used to offset non-business income to $250,000 for single filers and $500,000 for joint filers ($313,000 and $626,000 for 2025, respectively). For S corporation owners and partners in partnerships, these limits are accounted for at the individual level. The amount of the excess business loss is treated as an NOL carryover in the subsequent year, subject to the 80% limit.
These changes were effective for 2018 through 2025. The new One Big Beautiful Tax Act (OBBBA) generally extends these provisions permanently,
Although an NOL claimed by a C corporation may only offset its business income, self-employed individuals and owners of pass-through entities—like partnerships and S corporations—may reap the tax rewards on their personal returns. Nevertheless, to benefit from a NOL, they must show that they were actually operating a business.
Facts of the new case: A couple in Oregon, who had been successful entrepreneurs in the past, contracted to have a recreation lodge designed and built, starting in 2000. Unfortunately, deep snow and torrential rains in 2006 caused the lodge to flood. This resulted in defects in windows and roofing. Even worse, the couple discovered hundreds of bats living in the lodge’s walls along with rats and mice. The infestations cause a foul odor. Eventually, the building was condemned and torn down.
The couple engaged in various lawsuits relating to the recreation lodge. They did not report any NOL on their 2014 return. Subsequently, in 2018 they determined they were entitled to a 2014 NOL that they could carry forward to 2017. So, they amended their 2014 return and filed a 2017 return electing an NOL carryforward of $3.7 million. On their 2018 return, they claimed a 2014 NOL of $3.3 million. The IRS disputed the NOLs and issued deficiency notices.
Case closed: Despite their best intentions, the couple were not carrying on or operating a business during the tax year in question. They had a mere intention of starting a business. Therefore, the Tax Court sided with the IRS and denied the loss.
Be aware of the rules for NOLs going forward. A tax professional can help maximize the tax benefits.
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