Can a sole proprietor deduct losses?

One of the benefits enjoyed by a sole proprietor is their ability to use the category of loss known as a "net operating loss" to reduce  taxable income.

When a sole proprietor suffers a business loss, you first offset any current income with that loss. Amy loss in excess of current income becomes a net operating loss (NOL) and is carried back to prior years. Currently the losses can be carried back to the prior two years. Should there be any excess beyond the carryback period, you can carry the loss forward until it is used up or for 20 years, whichever comes first. The calculations of the NOL and carryover amounts are complex because the amounts are subject to many adjustments.  You can also elect to forego the carryback period and only carry the loss forward, but you have to make an election on a timely filed tax return or on an amended return with six months of the due date of the return including extensions. If you decide you do not want to carry back the loss, you can attach a statement to your tax return during the net operating loss year. Your statement must say you elect to forgo the carry-back period under section 172 of the Internal Revenue Service tax code.

The offset earnings may come from the proprietorship that suffered the loss, another proprietorship the same individual owns or from employee wages.

You start with the earliest year first, then apply the remainder of the loss to the years after that.

The easiest way for a sole proprietor to determine if she has one is to complete a tax return. If the adjusted gross income amount entered on Line 41 of IRS Form 1040 is a negative number, there may be a NOL.

File Form 1045, "Application for Tentative Refund." to claim your losses against previous tax years. You have one year from the end of the net operating loss year to file this form.

If you carry forward your NOL to a tax year after the NOL year, list your NOL deduction as a negative figure on the “Other income” line of Form 1040 or Form 1040NR (line 21 for 2013). Estates and trusts include an NOL deduction on Form 1041 with other deductions not subject to the 2% limit (line 15a for 2013).

You must attach a statement that shows all the important facts about the NOL. Your statement should include a computation showing how you figured the NOL deduction. If you deduct more than one NOL in the same year, your statement must cover each of them.