Considering Net Operating Loss When Choosing a Business Type

Net Operating Loss

If the taxpayer’s deductions for the year exceed gross income, the taxpayer may have a net operating loss (NOL). The NOL is used to reduce taxable income in other years. There are limits on the kinds of deductions, and the amounts, that can be used in computing an NOL. These limits are different for individuals and for corporations and for federal and Minnesota returns. For C corporations, if the NOL is attributable to business carried on both in and outside Minnesota, a computation allocating a portion of the NOL may be required on the Minnesota return. The 2009 American Recovery and Reinvestment Act (ARRA) amended the Internal Revenue Code to allow an “eligible small business” to carry back a 2008 net operating loss for three, four, or five years (rather than two years). An “eligible small business” is a taxpayer with $15 million or less in gross annual revenues in the tax year in which the 2008 net operating loss arose.

Sole Proprietorship

The NOL is determined on the proprietor’s gross income from all sources as reported on the Form 1040, not just on the income or loss from the business reported on Schedule C. I general, an NOL is computed in the same way taxable income is computed: deductions are subtracted from gross income, and if deductions exceed gross income there is a net operating loss. However, there are rules that limit what deductions may be taken in computing an NOL. In general, these rules do not permit a deduction for net capital losses, nonbusiness losses, nonbusiness deductions, personal exemptions and NOL carryovers or carrybacks from previous years. Some deductions also must be modified in taking the NOL. Internal Revenue Service regulations and those of the Minnesota Department of Revenue determine the years to which the NOL is carried, and the order in which NOLs are deducted.

Partnership

A partnership is not allowed to take an NOL deduction. All losses to the partnership for tax purposes are passed through to the partners each year. The partners may use their separate shares of the partnership’s loss to compute their individual NOL. The rules for sole proprietors discussed above apply.

C Corporation

For federal tax purposes, a C corporation determines and deducts an NOL in much the same way an individual does. The same carryback and carryover periods apply and the same rules apply when two or more NOLs are carried to the same year. A corporation’s NOL differs from an individual’s NOL in three ways. First, a corporation is allowed to take different deductions in figuring an NOL. Second, a corporation must make different modifications to its taxable income in the carryback or carry forward year when figuring how much of the NOL may be deducted. Third, Minnesota does not permit carryback of an NOL. (An NOL may be carried forward 15 years.) Because the corporation is a separate taxable entity, the NOL is deducted by the corporation and is not passed through to shareholders. Minnesota’s tax laws must be followed in taking the NOL deduction for Minnesota income tax purposes.

S Corporation

The S corporation, like a partnership, is not allowed to take an NOL deduction. If the S corporation incurs a loss for the year, it is passed through to shareholders in proportion to their shareholdings. The shareholders of the S corporation may use their share of the corporation’s loss to compute their individual NOL. Estimated Tax Payments

Sole Proprietorship

The sole proprietor generally will be required to make federal and Minnesota estimated tax payments if his or her income tax and (for federal purposes) self employment tax will exceed taxes paid through withholding and credits by $1,000 or more. The tax is determined on income from all sources, including income from the business. A penalty may be imposed on underpaid estimates. Partnership. The partnership itself is not required to make estimated tax payments. However, for Minnesota tax purposes, a partnership is required to pay quarterly estimated tax if its Minnesota minimum fee is $500 or more or if it has a nonresident partner whose share of the composite income tax is $500 or more. As with the sole proprietorship, individual partners generally will be required to make estimated tax payments if their income tax and self employment tax will exceed taxes paid through withholding and credits by $1,000 or more. The tax is based on taxable income from all sources, not just the income from the partnership. If the tax is underpaid, a penalty may be imposed on the partner. As with the sole proprietorship, both federal and Minnesota estimates generally will be required.

C Corporation

Federal: A C corporation whose estimated tax is expected to be $500 or more is required to make estimated tax payments. If the corporation does not use Electronic Federal Tax Payment System (EFTPS), deposit corporation income tax payments (and estimated tax payments) with Form 8109, Federal Tax Deposit Coupon. Mail or deliver the completed Form 8109 with the payment to an authorized depository (that is, a commercial bank or other financial institution authorized to accept federal tax deposits). Minnesota: A corporation with an estimated tax of $500 or more must make Minnesota quarterly estimated tax payments. In addition, a C corporation with more than $20,000 in tax liability must make all its tax payments via electronic funds transfer. These payments are filed with the Minnesota Department of Revenue. For both federal and Minnesota purposes, a penalty may be imposed for failure to pay the correct estimated tax on or before its due date. S Corporation. The S corporation is not subject to estimated tax on income which passes through to shareholders. For Minnesota tax purposes, an S corporation is required to pay quarterly estimated tax if its S corporation taxes and minimum fee is $500 or more or if it has a nonresident shareholder whose share of the composite income tax is $500 or more. A penalty may be applied if the estimated taxes are underpaid.


CREDITS: This is an excerpt from A Guide to Starting a Business in Minnesota, provided by the Minnesota Department of Employment and Economic Development, Small Business Assistance Office, Twenty-eighth Edition, January 2010, written by Charles A. Schaffer, Madeline Harris, and Mark Simmer. Copies are available without charge from the Minnesota Department of Employment and Economic Development, Small Business Assistance Office.

This is also part of a series of articles on How to Pick the Right Business Entity Type. These articles help you select the right business type for your circumstances.
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