Due to various restrictions on certain deductions and tax credits, you might not be able to use the entire amount of a write-off in the year it occurs. Instead, the unused portion can be carried forward to future years (or back in limited cases). Understanding how to track tax write-off carryovers can be quite beneficial.
Here are some of the most common carryovers for small business owners to watch for and the records you should maintain:
**General Business Credit**
There are more than 24 types of business credits, each with its own eligibility rules and maximum credit amount. However, these credits are subject to an overall limitation known as the general business credit. If your total credits exceed this limit, the excess is carried back one year and then forward for up to 20 years.
Keep track of each year when an excess general business credit arises and each year when a carryover is used. There is an ordering rule that applies: first, current deductions for any carryforwards to this year (starting with the earliest ones), second, business credits for the current year, and third, any carrybacks to this year (also starting with the earliest).
**Home Office Deduction**
If you have a home office and opt to deduct your actual expenses (instead of using the IRS simplified option), the deduction cannot exceed the gross income from the business use of the home minus business expenses (known as the “gross income test”). Any unused amount can be carried forward to future years, still subject to the gross income test. This applies even if you move to a new home. Carryovers can be used indefinitely, following the gross income test.
**Business Losses**
If your business expenses surpass your revenue, you face a financial loss that likely translates into a tax loss (although limitations on deductions might mean the loss in your books differs from your tax loss). If you own a business operating as a pass-through entity—a sole proprietorship, partnership, limited liability company, or S corporation—and a loss is passed through to you, your current deduction is limited by the noncorporate excess loss limitation rule.
An excess business loss is the amount by which the total deductions from all your trades or businesses exceed your total gross income and gains from those trades or businesses, plus a threshold amount adjusted for inflation (see instructions to Form 461). Any loss greater than this limit becomes part of a net operating loss (NOL), calculated with certain adjustments.
The NOL can be carried forward indefinitely to offset up to 80% of taxable income (farming businesses offer a 2-year carryback option). If there are multiple NOL carryforwards from different years, use them in the order they arose (oldest first). Attach a statement to your tax return detailing all the important facts about the NOL and how you calculated the NOL deduction. If you claim more than one NOL in the same year due to multiple carryovers, your statement must cover each one.
**Depreciation**
If you purchase certain property for your business and cannot fully expense the cost using first-year expensing (Section 179 deduction), bonus depreciation, or an IRS-created safe harbor (all detailed in IRS Publication 946), you will need to deduct an annual depreciation allowance. The depreciation period is legally fixed depending on the type of property. For instance, most business equipment and machinery are classified as 5-year or 7-year property, while commercial real estate has a 39-year depreciation period.
It’s crucial to track annual depreciation allowances to continue claiming these deductions until fully used up and to figure recapture of depreciation when required.
**Other Carryovers**
Other carryovers you might encounter include:
– Capital losses
– Charitable contributions
– Investment interest
– Passive activity losses
– Prepaid expenses
**Conclusion**
When it comes to carryovers, there’s both bad news and good news. The bad news is that you’re responsible for tracking them, as the IRS doesn’t do this for you. The good news is that tax preparation software (if you use the same one every year) or your CPA or tax professional can automatically keep the necessary records of carryovers. Ensure good recordkeeping to claim every write-off you’re entitled to.
