Capital Losses vs Ordinary Losses: What Business Owners Need to Know

How your business losses are classified by the IRS determines how much you can deduct, when you can deduct it, and whether the deduction carries over to future years. The difference between a capital loss and an ordinary loss is not just a technicality. It can mean thousands of dollars in tax liability depending on how your business is structured and how your transactions are reported.

At AmeriLawyer, operated by Spiegel and Utrera, P.A., our attorneys work with business owners across all 50 states to ensure their business structure is set up to maximize legal tax advantages from day one.

Capital Losses and Ordinary Losses Receive Different Tax Treatment

A capital loss results when you sell a capital asset, such as stocks and bonds, for less than your cost. An ordinary loss occurs from the normal operations of a business when expenses exceed income.

When capital losses exceed capital gains, a net capital loss occurs. Net capital losses can be deducted up to $3,000 from wages, interest, and dividends. If a net capital loss exceeds $3,000 then the excess must be carried over to the following year. Individual taxpayers cannot carry back any part of a net capital loss to a prior year. However, corporations do not have a deduction limit and can carry back portions of a capital loss to prior years, potentially generating a tax refund.

This difference between individual and corporate treatment is one reason why choosing the right business entity structure matters significantly for your long-term tax planning.

Advantages of Ordinary Losses

Ordinary losses are fully deductible in the year the loss was incurred and are not subject to a deduction limit. This makes them significantly more valuable from a tax perspective than capital losses, which are capped at $3,000 per year for individuals.

Common examples of ordinary losses for business owners include:

• Operating expenses that exceed business revenue in a given year
• Bad debts written off from unpaid client invoices
• Losses from the sale of inventory
• Losses on accounts receivable that cannot be collected

Section 1231: The Best of Both Worlds

If a loss is taken under Section 1231 of the Internal Revenue Code, it is fully deductible as an ordinary loss. Section 1231 applies to the sale or exchange of real or depreciable property used in a trade or business and held for over one year.

Another significant benefit under Section 1231 is that gains are taxed as long-term capital gains at the lower capital gains rates. This means:

• If you sell Section 1231 property at a gain, you pay the lower long-term capital gains tax rate
• If you sell Section 1231 property at a loss, you get the full ordinary loss deduction with no cap

Examples of Section 1231 property include commercial real estate used in your business, machinery and equipment used in your trade, and vehicles used for business purposes held for more than one year.

Section 1231 is one of the most taxpayer-friendly provisions in the tax code for business owners and is worth understanding before you sell any significant business asset.

How Business Structure Affects Your Loss Deductions

The type of business entity you choose directly impacts how losses flow through to your tax return and how much you can deduct each year.

Sole proprietorships and single-member LLCs pass losses directly to your personal tax return and can offset other income subject to passive activity and at-risk rules.

Partnerships and multi-member LLCs pass losses through to each partner or member based on their ownership percentage, subject to basis limitations.

S Corporations pass losses through to shareholders but are limited by each shareholder’s stock and debt basis in the company.

C Corporations retain losses at the corporate level. They do not pass through to shareholders but corporations have more flexibility in carrying losses back three years and forward five years.

Choosing the wrong entity structure can limit your ability to use business losses effectively. AmeriLawyer’s attorneys help you choose and maintain the right structure for your specific tax situation.

Short-Term vs Long-Term Capital Losses

Not all capital losses are treated the same. The length of time you held the asset before selling determines whether the loss is short-term or long-term.

Short-term capital losses come from assets held for one year or less. These losses first offset short-term capital gains, which are taxed at ordinary income rates.

Long-term capital losses come from assets held for more than one year. These losses first offset long-term capital gains, which are taxed at the preferential rates of 0%, 15%, or 20% depending on your income level.

When you have both short-term and long-term gains and losses in the same year, they are netted against each other in a specific order that can significantly affect your overall tax liability.

How AmeriLawyer Helps

Understanding how your losses are classified is important. But the real opportunity is in structuring your business correctly from the start so you can take full advantage of every legal deduction available to you.

AmeriLawyer is a full-service licensed law firm with its main offices in Miami, Florida and offices throughout the United States. As a law firm, we do more than help you form your business entity. We stand ready to help with the maintenance of your legal business entity, including:

• Business formation and entity selection for optimal tax treatment
• S Corporation elections and corporate structure changes
• Trademarks and copyrights
• Estate planning, wills, and trusts
• Agreements and leases
• Annual compliance and corporate records maintenance
• General Counsel Club membership for unlimited legal, business, credit, and tax advice all year long

If you are a member of Spiegel and Utrera, P.A.’s General Counsel Club and have business related questions, call (800) 734-9900 or email webclerk@amerilawyer.com for assistance. As a General Counsel Club member, you receive unlimited legal, business, credit, and tax advice all year long.

Not yet a member? Call us at (800) 603-3900, Monday to Friday from 8:30 am to 5:30 pm, or get started at amerilawyer.com today.