Here's the situation: I borrowed $100,000 to start a sole proprietorship, but my business failed after two years and I spent all the money. I do have $10,000 in assets left over from the business, however. I'm now an employee and earning $35,000 annually. My interpretation of the IRS rules would allow me to use the $100,000 in losses to reduce my personal income taxes.

You are correct in your interpretation of how to treat a business loss almost. When you suffer a business loss, you first offset any current income with that loss. Any loss in excess of current income becomes a net operating loss (NOL) and is carried back to prior years. Currently, the loss can be carried back five years, three years, or two years, depending on which carryback period results in the largest refund. Again, any excess NOL remaining after applying it to a given year is carried forward to the next year. Should there be any excess even beyond the carryback period, you can carry the loss forward until it is used up or for 20 years, whichever comes first. You can 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 in the year of the loss.

The calculations of the NOL and carryover amounts are complex because the amounts are subject to many adjustments for items like non-business deductions and exemptions, so I would recommend that you have the refund claim done by a tax professional.

You mention the hobby-loss rules in your question. The Internal Revenue Code allows for deductions for losses as long as there is a serious effort and intent to make a profit. Occasionally, people try to convert personal hobby activities into a loss-generating business. Congress passed a tax code section that essentially says it is up to the taxpayer to prove that the activity qualifies as a true business endeavor. This code section contains a presumption that if the activity makes a profit in three out of five years, it will qualify as a for-profit effort and losses can be deducted. This rules are only a presumption and can be rebutted.

Loella Haskew is a Walnut Creek, California, CPA with the firm of Buckley Patchen Riemann & Hall.

In accordance with IRS Circular 230, the information on this website is not intended or written to be used, and cannot be used as or considered a "covered opinion" or other written tax advice and should not be relied upon for the purpose of avoiding tax-related penalties under the Internal Revenue Code; promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein; for IRS audit, tax dispute or other purposes.