Tax Strategies for Pass-Through Losses

Most U.S. businesses use pass-through structures for one reason: the tax benefits in the case of both losses and gains. These business structures avoid double taxation by passing income to the owners' personal tax returns, where they pay income tax at their individual income tax rates.

If losses occur, timing and strategy matter. When done right, they reduce your taxable income and slash your overall tax bill.

Business Structures That Allow Pass-Through Losses

Not all businesses qualify. The structure determines whether losses pass through and land on the business owner's personal return.

• Sole Proprietorships and Single-Member Limited Liability Companies (LLCs): Losses reduce the owner's taxable income unless the LLC elects corporate taxation.

• Partnerships and Multi-Member LLCs: Losses are split among owners and reported individually.

• S Corporations: Shareholders deduct their share of losses, but only up to their basis and subject to participation rules.

• C Corporations (Not Pass-Throughs): C corps pay corporate income taxes. Shareholders can't use corporate losses to offset personal income.

How Pass-Through Losses Affect Your Personal Tax Return

You can claim business losses against your other income on IRS Form 1040. Other income includes your wages, interest, and dividends. This may reduce your federal income tax and self-employment tax.

Report them on the right forms:

• Form 1040 for the overall tax impact

• Schedule C for sole proprietors and single-member LLCs

• Schedule E for partnerships and S corporations

Limitations on Using Pass-Through Losses

Losses aren't automatically deductible. IRS rules determine what you can claim.

Basis Limitations

Your deductible losses cannot exceed your adjusted basis in the business. The basis includes your initial investment, increases in income, and decreases from distributions or losses. Excess losses beyond your basis are suspended until you increase it by additional contributions or income.

At-Risk Rules (IRC §465)

You may only deduct losses up to the amount you're personally at risk. This includes your cash investment and any personally guaranteed loans. Suspended losses unlock once you increase your risk, for example, by adding capital or debt.

Pro Insight: Many small business owners overlook basis or at-risk limits until the IRS denies a deduction. A small business tax professional can track these thresholds and help you take your deductible losses now (not years later).

Passive Activity Loss Rules (IRC §469)

Passive losses only offset passive income. This affects rentals and businesses where you don't materially participate. Suspended losses carry forward until you generate passive income or dispose of the activity.

Many business owners are shocked to learn they can't deduct losses from rental properties or side businesses unless they materially participate. Engaging a tax professional early on can help you group activities and meet material participation tests to unlock deductions.

Excess Business Loss (EBL) Limitations (IRC §461(l))

This tax law was introduced under the Tax Cuts and Jobs Act (TCJA) and applies to tax years 2018 through 2025. It caps how much loss you can deduct annually. Furthermore, you can't carry losses back to prior years, only forward.

In 2025, non-corporate taxpayers may deduct up to $313,000 ($626,000 if filing jointly). Any excess becomes an NOL and carries forward, subject to an 80% limitation against future income.

Pro Insight: Many small business owners don't realize excess losses get suspended and can't offset their income in the current tax year. A tax planning specialist helps you structure timing and deductions to avoid hitting IRS limits.

Schedule an appointment with our accounting professionals to time deductions strategically and make the most of your pass-through losses.

Strategies to Maximize Pass-Through Losses

Use these strategies to unlock and apply losses that lower your tax bill.

1. Time Income and Expenses

Cash-method businesses can shift income or expenses to control when losses hit. Delaying billing or prepaying expenses can create larger losses in high-income years.

Example: You expect a big bonus from your job this year, but your side business is going to take a loss. You delay billing your business clients until January and prepay expenses before the end of the tax year. This boosts this year's loss and cuts your tax bill.

2. Offset Future Income With Net Operating Loss (NOL) Carryforwards

An NOL occurs when deductions exceed income in a tax year. Pass-through losses limited by EBL rules can be carried forward indefinitely to offset future income (up to 80% per year).

Expert Tip: NOL tracking is tricky, especially with shifting IRS rules. Working with a tax professional ensures your losses carry forward correctly and are used when they'll save you the most.

3. Offset Income Across Business Entities

Losses from one pass-through can offset income from another, as long as both flow through to your personal return. This reduces your adjusted gross income (AGI) and overall tax liability.

This strategy may also help you stay below AGI thresholds that reduce other deductions or trigger additional taxes, such as the net investment income tax (NIIT) or the additional Medicare tax. In some cases, it also helps preserve the qualified business income (QBI) deduction.

4. Group Passive Activities to Unlock Deductions

The IRS limits loss deductions from passive activities unless you materially participate. However, you can group related passive activities into a single “appropriate economic unit” under Reg. §1.469-4. This allows you to combine hours across activities to meet the material participation tests.

Example: You own three rental properties in Jacksonville, FL. None qualify on their own under the 500-hour rule. But when grouped, the combined hours meet the threshold allowing you to deduct all losses.

5. Increase Your Basis in the Business

You can only deduct pass-through losses up to your basis in the business. Basis includes your capital investment, additional contributions, and your share of income. Losses exceeding your basis are suspended and carried forward until your basis increases.

One way to increase basis is by personally guaranteeing business debt, which the IRS treats as if you loaned the money yourself. More basis means you can deduct more losses now and reduce this year's tax bill.

6. Plan Around Filing Status and AGI Thresholds

Joint filers have a higher EBL threshold than single filers. A lower AGI also helps preserve deductions like QBI and avoid phaseouts of other tax benefits.

Coordinating income timing and filing status increases the value of your losses and unlocks deductions you'd otherwise lose.

7. Get Ahead of IRS Scrutiny

The IRS now has a specialized audit unit focused on pass-through entities. These teams are already reviewing returns more closely,

The strategies above are generally effective, but they need to be applied carefully. A tax planning specialist will help you navigate the rules with confidence, so you're prepared, not panicked, if the IRS comes calling.

Turn Pass-Through Losses Into Tax Advantages

Pass-through losses offer powerful tax-saving opportunities for small business owners. However, the IRS limits how and when you can use them.

Work with a tax professional to apply these rules to your situation. Strategic planning ensures your losses reduce taxes now and in future years.