If you earn money through self-employment, you report it on Schedule C. If your business ends up running at a loss for the year, you may be able to deduct the losses from your other income. In some cases, however, you'll have to either carry the loss forward and deduct it in a later year or carry it into the past.
Your business has a net loss anytime the expenses for the tax year add up to more than your business income. If you have other sources of income for the year, you can record your loss on the front of your 1040 form and subtract it to figure your net income for the year. If the net figure is in the red -- you lost more than your total income -- you may have to deduct some of your business loss from another tax year.
If you claim a net operating loss on Form 1040, the IRS will disallow some of your deductions to lower your loss. You could lose your standard exemption and your standard deduction for the year, and possibly other nonbusiness deductions. If claiming a deduction for the business use of your home puts your business in the red, you can deduct only enough home expenses to zero out your business income -- the rest of the deduction must be carried forward regardless of whether your total income is a loss or not.
Forward and Back
If you have to carry over some of your loss, the first step is to deduct as much as possible from your previous two years' taxes and submit adjusted returns. If your business has annual receipts under $5 million, you can subtract from three years instead of two. Whatever remains after you've carried the loss back must be carried forward, year after year, until you've wiped out the loss or 20 years have passed. You can choose to only carry the loss forward and dispense with the carry-back period.
Business or Hobby
If the IRS classes your self-employment as a hobby rather than a business, you can deduct your expenses from only self-employment income, not from your other income. The IRS standards for a business include whether you depend on the income to support yourself; whether you work to make it profitable; that you do show a profit in some years; and that the losses were beyond your control. If you don't meet the standard, you can report zero business income, but not a loss.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.