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If you invest $50k into a business venture that fails, your losses will be limited to the $50k invested.
This is a question I often get from higher income earners looking to minimize their tax liabilities. It’s understandable to want to keep more of our hard-earned money from the sticky fingers of the IRS, but having business losses may not always have the impact you are hoping for.
This topic can get very deep, so we are going to stay very surface level here. Not all business income is the same - The IRS considers some income as passive, other income as active. Each has its own set of guidance, regulations, and rules on how to apply the various income streams.
I cannot deduct passive loss against active income. So, a taxpayer throwing money at a business investment in which they will have zero involvement regarding their time is impossible to offset business gains from their primary business where they do devote all of their time.
In general, the IRS has thought through most ways we could easily game the system as taxpayers. It really doesn’t make sense to be able to deduct losses for more skin than one has in the game, so there is a whole section of Internal Revenue Code devoted to policing this. Originally adopted in 1976, Sec 465 addresses the At-Risk Limitations for deducting business losses.
If you invest $50k into a business venture that fails, your losses will be limited to the $50k invested. As such, the belief that one can invest in a business with the goal of continuing to lose money in excess of their investment and experience tax benefits is false.
Losses in excess of investment are not lost forever though. They can be carried forward to a time when the business does have income to offset it. I do see this commonly early on in startups. Some of the capital they have used is borrowed and as such their losses have exceeded their initial investment from owner(s). Those losses cannot be deducted during that tax year, but yield future benefits by offsetting income once the entities became profitable.
Bottom line, the IRS’s view of businesses is that they are held for profit and not a hobby. If a business goes long enough without showing profits, there can be complications with the IRS which cause you to lose all business deductions. For more information on At-Risk Loss Limitations, the link below may be helpful.
