Writing Off Small Business Losses

Q: Dear Tax Talk,
My husband and I own an electrical contracting business. I, not having prior business-management knowledge, have had to learn as we go.

Our business is an LLC. We did not realize that meant that whatever income the business earned would be added to our personal income, nor were we advised that we needed to make quarterly income tax deposits for our business income to avoid having to pay an unexpected chunk when taxes were filed.

We learned this lesson when we filed our taxes for 2007 and had to pay nearly $6,000 between federal and state taxes owed. In 2008, we've done everything we can to make quarterly tax deposits, however, not quite what we'd hoped we'd be able to do. We were way less profitable in 2008 than in 2007.

In a span of four months, we had to lay off our only two employees as we had six jobs that we've yet to get paid for, totaling more than $20,000. Because our customers weren't paying, we couldn't pay our bills and our supplier shut down our accounts. At that time, we owed our supplier nearly $60,000.

Today, we only have $2,000 of that debt left to pay. I'm procrastinating when it comes to going to our CPA to do our taxes because we don't have a dime to pay a large tax debt. We're doing everything we can to stay afloat, make a profit, and complete hurricane and tornado repairs from last summer.

Our profit and loss statement shows our net income for 2007 was $25,000. In 2008, our net income was negative $47,000. Is there a possibility that we may claim a loss due to our nonpaying customers or negative profit and loss statement; or maybe get a refund for the income tax deposits of around $2,100 that we did make?
-- Michelle

A: Dear Michelle,
Only your CPA will know for sure whether you have a loss for income tax purposes. A lot will depend on the method of accounting used for income taxes.

Within certain limitations, when you start a business you can choose to use either the accrual or cash basis method of accounting. If your CPA used the accrual basis of accounting, you maybe able to write off the accounts receivable that are owed to you in 2008 that may not be collectible.

The debt you owed your suppliers would be a write-off in 2008, even though you may have paid part of it in 2009. If the result is as your profit and loss statement shows, you may have an overall loss on your personal taxes. An overall loss will help you get back what income taxes you paid in 2008 and maybe the income taxes you paid in an earlier year.

Under the Obama stimulus plan, small businesses can claim a loss carryback to up to five years prior. The carryback is highly flexible and most beneficial if you paid large taxes in earlier years, even if those taxes weren't as a result of your current electrical contracting business.

Under the prior rules, all businesses had the option to carryback their overall tax losses for the prior two tax years. This would mean that if you had an overall loss in 2008, you could use it to offset income taxes you paid in 2006 and then the balance, if any, could be used to offset income taxes paid in 2007.

There was no flexibility in which prior year you first used the loss. Under the Obama changes, if you're a small business, you can carryback to any of your five preceding tax years, but starting at least two years prior. This means you can choose the year -- from 2003 through 2006 -- in which you paid the most income taxes to maximize your refund.

A carryback of losses will offset prior income tax, including the alternative minimum tax, but not self-employment taxes. A small business is a business that has grossed an average of less than $15 million for the last three years.

It's a great time to go visit your accountant early and take along your prior-year individual income tax returns.