You can deduct business losses from personal income only when the business is a pass-through entity, and even then each dollar of loss has to survive four separate limitation rules before it reaches your Form 1040. Sole proprietorships, partnerships, LLCs, and S corporations pass their results straight to your individual return, so a bad year at the business can reduce your wages, investment income, and other earnings. For 2026, the largest net business loss you can actually deduct against other income is capped at $256,000 for single filers and $512,000 on a joint return.1Internal Revenue Service. Rev. Proc. 2025-32 Anything above that becomes a carryforward for future years.
Which Business Structures Allow It
Pass-through entities are the only structures that let a business loss touch your personal return. The business itself pays no income tax; profits and losses flow to the owners and get reported on individual returns.2Cornell Law School. Pass-Through Taxation Sole proprietorships, general partnerships, LLCs, and S corporations all work this way.3Internal Revenue Service. Sole Proprietorships If you own a piece of any of them, your share of the loss shows up on your tax return whether or not the business sent you a check.
C corporations do not work this way. A C corporation is its own taxpayer, and its losses stay locked in the corporate return. Owning stock in a C corporation that lost money gives you no personal deduction, no matter how much you put in. Those losses carry forward on the corporate side only.4Office of the Law Revision Counsel. 26 USC 382 – Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change
Is It a Business or a Hobby?
None of the loss rules matter if the IRS decides your activity is a hobby. Hobby losses cannot be used to offset other income at all.5Internal Revenue Service. Know the Difference Between a Hobby and a Business There is a safe harbor: an activity that shows a profit in at least three of any five consecutive years is presumed to be run for profit. For horse breeding, training, showing, or racing, it’s two profitable years out of seven.6Office of the Law Revision Counsel. 26 USC 183 – Activities Not Engaged in for Profit
Missing the safe harbor doesn’t automatically make something a hobby, but it does invite closer scrutiny. The IRS will look at whether you keep real business records, whether you depend on the income, and whether you adjust methods to try to improve profitability.7Internal Revenue Service. Is Your Hobby a For-Profit Endeavor?
The Four Loss Limits, in Order
Assuming you have a real business, your loss runs through four filters in a fixed sequence: basis, at-risk, passive activity, and the excess business loss cap. A loss disallowed at an earlier stage never reaches the next one. Where the loss gets stopped determines how, and when, you eventually recover it.
Basis
Basis is your financial stake in the business: money and property you contributed, plus your share of accumulated profits, minus distributions and losses already claimed. You cannot deduct losses greater than that number. S corporation shareholders can also count loans they personally made to the company.8Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders Partners and LLC members are capped at the adjusted basis in their partnership interest.9Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share
Losses blocked by basis carry forward indefinitely. They become deductible when you rebuild basis, usually by contributing more capital or by the business earning income.
At-Risk
Losses that clear basis next face Section 465. Your at-risk amount is what you could actually lose: cash contributed, adjusted basis of property contributed, and borrowed amounts you are personally on the hook to repay.10Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
Nonrecourse debt generally doesn’t count. If the lender can only reach the business’s assets and can’t come after you personally, that borrowing doesn’t lift your at-risk figure. The same is true for amounts covered by guarantees or stop-loss arrangements. Losses stopped here carry forward until your at-risk amount grows enough to absorb them.
Passive Activity
This filter separates operators from investors. If you don’t materially participate, the loss is passive and can only offset passive income, not your salary, self-employment earnings, or portfolio income.11Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
There are seven material participation tests, and you only need to pass one. The clearest is more than 500 hours of participation in the activity during the year. You can also qualify if your participation was substantially all of the participation by anyone, or if you logged over 100 hours and no one else put in more than you. There’s a facts-and-circumstances test for regular, continuous, and substantial involvement that doesn’t fit the other buckets.12Internal Revenue Service. Instructions for Form 8582 Owners who materially participated in any five of the previous ten years continue to qualify, which protects people who have scaled back.
Rental real estate gets its own carve-out. If you actively participate in a rental, you can deduct up to $25,000 of rental losses against nonpassive income without meeting the material participation standard. Active participation is a lower bar: approving tenants, setting rents, and authorizing repairs generally counts. The $25,000 allowance phases out as adjusted gross income rises above $100,000 and disappears at $150,000.11Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited Married filing separately, if the spouses lived together at any point in the year, cannot use the allowance at all.
The Excess Business Loss Cap
Anything that survives the first three filters meets one final ceiling. For 2026, deductible net business losses top out at $256,000 for single filers and $512,000 on a joint return.1Internal Revenue Service. Rev. Proc. 2025-32 The thresholds adjust for inflation. Originally temporary under the 2017 tax law, the cap is now permanent.13Office of the Law Revision Counsel. 26 USC 461 – General Rule for Taxable Year of Deduction
Loss above the cap converts into a net operating loss carryforward. The rule targets high-income taxpayers using very large business losses to wipe out investment income or capital gains in a single year, and it applies only after the earlier three filters have already done their work.
What Happens When Losses Exceed All Your Income
If the allowed business loss is big enough to zero out your entire taxable income for the year, you have a net operating loss. Losses arising after 2017 carry forward indefinitely, but in any future year they can offset only up to 80% of taxable income.14Internal Revenue Service. Instructions for Form 172 Some tax will always be due in a carryforward year, no matter how large the accumulated NOL.
Carrying an NOL back to earlier years is not available to most taxpayers. Farming losses and losses of non-life insurance companies get a two-year carryback; other filers move NOLs forward only.15Office of the Law Revision Counsel. 26 USC 172 – Net Operating Loss Deduction The IRS does not track your NOL balance for you, so keep your own running record.
How a Loss Affects Self-Employment Tax and the QBI Deduction
Losses don’t only move your income tax. If you run more than one business as a sole proprietor, a loss from one reduces the combined net earnings on your Schedule SE, cutting the Social Security and Medicare tax owed on the profitable one.16Internal Revenue Service. 2025 Instructions for Schedule SE (Form 1040)
The qualified business income deduction under Section 199A works similarly. A loss from one business nets against QBI from the others, shrinking the amount that qualifies for the 20% deduction. If your combined QBI for the year is negative, the whole negative amount carries forward and reduces future QBI deductions until it’s absorbed.17Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income
Where the Loss Gets Reported
The form depends on the entity. Sole proprietors use Schedule C, attached to Form 1040.18Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship)19Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040) – Profit or Loss From Business Partners and LLC members work from a Schedule K-1 issued by the partnership;20Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065) S corporation shareholders use a K-1 from Form 1120-S.21Internal Revenue Service. 2025 Shareholders Instructions for Schedule K-1 (Form 1120-S) Form 6198 handles the at-risk calculation and Form 8582 applies the passive activity rules. The final allowed loss flows through Schedule 1 into Form 1040, where it reduces adjusted gross income.22Internal Revenue Service. 2025 Schedule 1 (Form 1040)
Keep contemporaneous records of contributions, distributions, and basis. Reconstructing those numbers years later is one of the most common problems in claiming a business loss, and errors can produce disallowed deductions and penalties long after the loss year is closed.