John Sculley III, who was the president of PepsiCo, until he became the CEO of Apple Inc. for more than a decade, said “timing is everything.” He was probably referring to business moves, but the sentiment applies with equal force to tax write-offs. Due to various limitations on certain deductions and tax credits, you may not be able to use the full amount of a write-off in the year in which it arises. Instead, the unused amount may be carried forward and used in future years (or back in limited situations). Fully utilizing write-offs you’re entitled to means carefully tracking these carryovers. Here are some of the most common carryovers for small business owners to look for and the records you should keep.
General business credit
Business credits—and there are more than 2 dozen of them—all have their own rules on eligibility, including the maximum credit amount. However, these credits are subject to an overall limitation called the general business credit. If total credits exceed the limitation, the excess is carried back one year and then forward for up to 20 years.
Keep track of each year in which an excess general business credit arises and each year in which a carryover is used. This is because there is an ordering rule that allows a current deduction first for any carryforwards to this year (the earliest ones first), second the business credits for the current year, and third any carrybacks to this year (the earliest ones first).
Home office deduction
If you have a home office and don’t use the IRS simplified option but instead deduct your actual expenses for business use of your home, the deduction cannot exceed gross income from the business use of the home minus business expenses (“gross income test”). Any unused amount may be carried forward and used in a future year to the extent of the gross income test. This is so even if you relocate to a new home. Carryovers can be used indefinitely, subject to the gross income test.
Business losses
If your business expenses exceed your revenue, you certainly have a financial loss and you probably also have a tax law (limitations on deductions can mean there’s a difference between the loss on your books versus your tax loss). Suppose 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 a tax rule called the noncorporate excess loss limitation. An excess business loss is the amount by which the total deductions attributable to all of your trades or businesses exceed your total gross income and gains attributable to those trades or businesses plus a threshold amount adjusted annually for inflation (see instructions to Form 461).
Any loss in excess of this limit becomes part of a net operating loss (NOL). The NOL deduction is figured using certain adjustments. The NOL may be carried forward indefinitely to offset up to 80% of taxable income (farming businesses have the option of a 2-year carryback as well). If there are NOL carryforwards from multiple years, use them in the order in which they arise (i.e., the oldest ones are used first).
You must attach a statement to your tax return showing all the important facts about the NOL. The statement should include a computation showing how you figured the NOL deduction. If you deduct more than one NOL in the same year due to multiple carryovers, your statement must cover each of them.
Depreciation
If you buy certain property for your business and you can’t fully expense the cost using the first-year expensing (Sec. 179 deduction), bonus depreciation, or a IRS-created safe harbor (all of which are explained in IRS Publication 946), you are left with deducting an annual depreciation allowance. The depreciation period is a fixed number of years set by law which depends on the type of property involved. For example, most business equipment and machinery is 5-year or 7-year property, while commercial realty has a 39-year depreciation period.
It is essential to track annual depreciation allowances so you can:
- Continue to claim these deductions until used up
- Figure recapture of depreciation where required
Other carryovers
This list is not exclusive, but some other carryovers you may encounter relate to:
- Capital losses
- Charitable contributions
- Investment interest
- Passive activity losses
- Prepaid expenses
Conclusion
When it comes to carryovers, there’s bad news and good news. The bad news is that it’s up to you to track them; the IRS doesn’t do this for you. The good news is that tax preparation software (assuming you use the same year after year) or your CPA or other tax professional will automatically keep required records of carryovers. Don’t let bad recordkeeping prevent you from claiming every write-off to which you are entitled.
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Barbara Weltman