Tax Talk Thursday: Business Losses and NOL Planning Strategies

A losing year in your business isn't just bad news to survive — it's a tax attribute to manage. Between basis limits, at-risk rules, passive activity restrictions, the excess business loss cap, and the net operating loss (NOL) rules that pick up whatever's left, a single loss can pass through four or five separate gauntlets before it actually reduces your tax bill. And thanks to the One Big Beautiful Bill Act (OBBBA), signed into law in July 2025, one of those gauntlets just got tighter for 2026. If you're carrying — or expecting — a business loss this year, now is the time to understand the order of operations and plan around it, rather than discovering the limits after the return is filed.

Why This Matters More in 2026

For years, practitioners could treat the excess business loss limitation under IRC Section 461(l) as a temporary rule on a slow, predictable inflation climb, originally scheduled to sunset after 2028. The OBBBA changed both facts at once: it made the limitation permanent, and it reset the inflation-adjustment methodology back toward the original 2018 baseline. The practical result is that the threshold is falling, not rising, for the first time since the rule was enacted.

For tax years beginning in 2026, the excess business loss threshold is $256,000 for single filers and $512,000 for married couples filing jointly — down from $313,000 and $626,000 in 2025. That's roughly $57,000 (single) or $114,000 (joint) less loss available for immediate use, with the remainder pushed into an NOL carryforward instead of a current-year deduction.

The Order of Operations: Four Gates Before a Loss Becomes Useful

Before a business loss can offset your other income, it has to clear each of the following tests, in sequence. Applying them out of order — or skipping one — is one of the most common errors we see on self-prepared and even professionally prepared returns.

1.      Basis limitation. A pass-through owner (S-corp shareholder or partner) can only deduct losses up to their basis in the entity. Losses beyond basis are suspended and carried forward until basis is restored.

2.      At-risk rules (Section 465). Even with sufficient basis, you can only deduct losses to the extent you have real economic exposure — cash invested, property pledged, or debt for which you're personally liable. Nonrecourse financing on most activities outside real estate doesn't count.

3.      Passive activity loss rules (Section 469). If you don't materially participate in the activity, losses are “passive” and can only offset passive income. Excess passive losses are suspended and carried forward until you have passive income or dispose of the activity.

4.      Excess business loss limitation (Section 461(l)). Only after a loss clears basis, at-risk, and passive activity hurdles does it reach this gate. Section 461(l) caps how much aggregate business loss a noncorporate taxpayer can use against nonbusiness income (wages, portfolio income, and the like) in a single year.

Whatever doesn't survive gate four doesn't disappear — it converts into an NOL carryforward, subject to its own separate limitation in future years.

Net Operating Losses: The Current Rules

Once a loss clears the four gates above and still exceeds your other taxable income, it becomes an NOL. Under the rules in place since the Tax Cuts and Jobs Act (and unchanged by the OBBBA):

•      No carryback, with narrow exceptions. Most NOLs generated today can only be carried forward, not back to prior years. (Certain farming losses and property and casualty insurance companies retain limited carryback rights.)

•      Carryforward is indefinite. Unlike pre-2018 law, there's no 20-year expiration on the carryforward period.

•      The 80% cap. An NOL carried forward can offset no more than 80% of taxable income (computed before the NOL deduction) in the year it's used. This means even a large NOL can't zero out a profitable year entirely — some tax will be due.

•      Form 461 does the work. The excess business loss calculated on Form 461 flows through as an addback to income, and that same disallowed amount becomes part of your NOL carryforward for future years.

A Closer Look at Section 461(l)

A few mechanics of the excess business loss rule catch clients by surprise every year:

•      Applies to noncorporate taxpayers only. Individuals, trusts, and estates are subject to it; C corporations are not — a point that matters when comparing entity structures for a business expecting recurring large losses.

•      W-2 wages are invisible to the calculation. Under Section 461(l)(6), wage income and related deductions are excluded from both sides of the test. A client with $400,000 in wages and a $300,000 Schedule C loss has no excess business loss at all — the wages simply aren't part of the equation.

•      Common trigger: accelerated depreciation. Cost segregation studies paired with 100% bonus depreciation on real estate are one of the most frequent causes of a large first-year loss landing in excess-business-loss territory.

•      The math bites harder in 2026. A single filer who generates a $400,000 loss via cost segregation would have kept $87,000 more of that loss usable in 2025 than in 2026, purely because the threshold dropped — at a 35% marginal rate, that's roughly $20,000 of tax that shows up a year earlier than the client may have modeled.

Planning Strategies to Consider

1. Model Section 461(l) exposure before you commit to a loss-generating transaction

Before finalizing a cost segregation study, a large equipment purchase, or a bonus depreciation election in the fourth quarter, run the numbers against the current $256,000 / $512,000 threshold. The current-year benefit may be smaller than the client expects, with the balance deferred into a carryforward subject to the 80% limitation.

2. Time income and deductible expenses across years

If you have flexibility over invoicing, contract timing, or discretionary expenses, consider whether shifting income into an otherwise-loss year (or accelerating deductible costs into it) lets you use more of the current year's threshold, rather than letting the excess convert into a carryforward you may not need for years.

3. Revisit entity structure for recurring-loss businesses

Because Section 461(l) applies only to noncorporate taxpayers, a business that expects large losses year after year — an R&D-heavy startup, for example — may find that operating as a C corporation avoids the individual-level cap entirely. C-corp NOLs still face the 80% taxable-income limitation and no carryback, but they aren't subject to the threshold test. This has to be weighed against the tradeoffs of corporate double taxation once the business turns profitable.

4. Confirm real estate professional status before relying on it

Qualifying as a real estate professional and materially participating can convert rental losses from passive to nonpassive, clearing gate three. But that only gets a loss to the excess business loss test — it doesn't exempt it. Large real estate losses can still be capped at gate four even for a qualifying real estate professional.

5. Track suspended losses at every gate, not just the final number

Basis, at-risk, and passive losses can all be suspended simultaneously in different amounts. A capital contribution, a debt guarantee, or a change in participation level can release suspended losses in a later year when there's income to absorb them — but only if those carryforwards have been tracked correctly since the year they were first suspended.

6. Consider Section 1244 treatment for qualifying small business stock losses

If the business is a qualifying C corporation and stock becomes worthless or is sold at a loss, Section 1244 allows up to $50,000 ($100,000 for married filing jointly) of that loss to be treated as ordinary rather than capital — avoiding the $3,000 annual capital loss limitation and freeing up the loss to offset ordinary income immediately.

7. Use asset disposition timing deliberately

Recognizing gain in the same year as a large loss can absorb that loss immediately, rather than letting it convert into an NOL that's later capped at 80% of taxable income. Conversely, an installment sale can spread gain across future years to better match against NOL carryforwards you already expect to be using.

8. Coordinate with the Qualified Business Income deduction

A business loss reduces qualified business income, and negative QBI carries forward to offset QBI in future profitable years. Any strategy built around maximizing a current-year loss deduction should also account for what it does to QBI deduction value going forward.

9. Never assume state conformity

Carryback availability, carryforward periods, the 80% limitation, and the excess business loss rule itself are not uniformly adopted at the state level. A federal NOL doesn't automatically produce a matching state tax benefit — state treatment has to be modeled separately for every jurisdiction where the business operates.

A business loss is a tax attribute with its own life cycle — it has to clear basis, at-risk, and passive activity rules before the excess business loss limitation even applies, and whatever survives all four gates still has to work its way through the NOL rules in future years. With the Section 461(l) threshold now permanently indexed off a lower 2026 baseline, more taxpayers will find part of their loss deferred than in years past, which makes proactive modeling — not year-end guesswork — the difference between a loss that helps you now and one that sits on the books for years.

•      Run a multi-year projection before finalizing any transaction expected to generate a large business loss.

•      Track basis, at-risk, and passive loss carryforwards separately — don't wait until there's income to absorb them to figure out what's actually available.

•      Revisit entity structure if your business expects recurring losses well above the current thresholds.

•      Model state-level treatment alongside federal — don't assume they match.

If you're planning a transaction that could trigger a large business loss, or you're carrying NOLs and want to make sure they're being tracked and applied correctly, MKHS Tax Group can help you model the outcome before you're locked in. Reach out to us at info@mkhstaxgroup.com.