If you're a small business owner or self-employed person, what do you do if you have little or no income this year, along with substantial expenses? Do you have to report and deduct those expenses in the year in which they are or paid or incurred? Or can you wait until next year, when you have more income, and deduct them then? Read on to get the answers to these questions.
The short answer to these questions is this: you must deduct expenses on the income tax return for the year in which they are paid or incurred. Each year stands on its own. You don't get to pick and choose which year to report your expenses.
Having said that, there is an important issue here that comes into play – are you reporting your business with the cash method of accounting or the accrual method of accounting? If you use the cash method, you should deduct expenses in the year in which they are paid. So it would be possible for you to receive an invoice in one year, but not pay it until the next year. In that situation, you would take a deduction in the year you paid the bill, not the year you received the bill.
If you use the accrual method, you deduct expenses in the year in which they are incurred, regardless of when they are paid. So any expense for which you have received an invoice would get reported on the tax return of the year you received the invoice, even if you waited until the next year to pay the invoice.
How do you know if you use the cash method or the accrual method? Look on last year's income tax return. There is place on every business income tax returns where the taxpayer must tell the IRS which method is being used. For example: sole proprietors, see Schedule C, Line F. Generally speaking, you should continue to use the method you've been using. Switching from one method to the other can get really tricky, so it's usually best to keep it the same.
Now let's go back to the original question: If you're in a situation in which your current year expenses are much greater than your income, the business will report a loss. And if your business is your only source of income, do not despair, because you can probably use that loss to offset income from another year. The tax rules allow you to "carry back" and/or "carry forward" a loss from one year to offset income from another year. These rules can be complicated, so check with a tax pro to get the details.
And if do have other sources of income in the year of your business loss (from a spouse, for example), your business loss can often be used as a deduction against that other income. This is generally true for losses from sole proprietorships and so-called "pass-through" entities (partnerships, S Corporations, and LLC's being taxed as a partnership or S Corporation). If your business is a C Corporation, you can only carry the loss forward to offset corporate profit in a future year. Again, if you need help sorting this out, do not hesitate to get some professional assistance. Thousands of dollars in tax savings could be at stake.
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