A trade or business exists when the taxpayer engages in an activity with a profit motive and participates with continuity and regularity. Profit is not required every year, but the taxpayer must make ongoing, good‑faith efforts to operate the activity for income.
Courts have established two requirements for a trade or business:
- Profit motive — genuine intent to earn a profit
- Regular, continuous activity — more than sporadic involvement
Hobbies do not qualify. Certain activities, such as gambling, may qualify depending on facts and circumstances.
Where Business Income Appears
Business income or loss may appear on:
- Schedule C — sole proprietors, independent contractors
- Schedule D — capital gains/losses from business assets
- Form 4797 — sales of business property
- Schedule E — partnerships, S corporations, royalties, rental real estate
- Schedule F — farming
- Unemployment compensation
- Other income from a trade or business
Section 162 allows deductions for ordinary and necessary business expenses. Section 262 disallows personal expenses.
Self‑Employment Income
A self‑employed taxpayer reports business income and expenses on Schedule C. Net profit becomes part of gross income and is subject to self‑employment tax.
Partnership and S Corporation Income
Partnerships and S corporations are pass‑through entities. They file informational returns and issue Schedule K‑1 to owners.
Owners report:
- Income
- Deductions
- Credits
- Gains/losses
on Schedule E, based on their K‑1.
Business Loss Limitations
Four limitations apply in order:
- Basis limitation
- At‑risk limitation
- Passive activity limitation
- Excess business loss limitation
A loss must pass each limitation before it can offset ordinary income.
- Basis Limitation
A taxpayer cannot deduct losses exceeding their basis in a partnership or S corporation interest. Disallowed losses carry forward indefinitely.
- At‑Risk Limitation
Losses are allowed only to the extent the taxpayer is at risk in the activity.
Amounts at risk include:
- Cash contributed
- Adjusted basis of property contributed
- Borrowed amounts for which the taxpayer is personally liable or secured by personal property
Amounts not at risk include:
- Nonrecourse loans not secured by taxpayer property
- Amounts protected by guarantees or stop‑loss agreements
- Loans from persons with an interest in the activity (other than as a creditor)
- Passive Activity Limitation
Passive losses may offset only passive income.
Passive activities include:
- Business activities without material participation
- Rental activities, unless the taxpayer is a real estate professional
Excess passive losses carry forward.
Material Participation Tests
Participation is material if the taxpayer meets any of these:
- 500+ hours
- Substantially all participation
- 100+ hours and more than anyone else
- Significant participation activities totaling 500+ hours
- Regular, continuous, substantial participation
- Material participation in 5 of 10 prior years
- Material participation in 3 prior years in a personal service activity
- Excess Business Loss Limitation
This limitation applies after basis, at‑risk, and passive rules.
For 2025:
- Threshold: $313,000 (single)
- Threshold: $626,000 (MFJ)
Excess business loss = Total business deductions − Total business income − Threshold amount
Excess business losses become NOL carryforwards.
Net Operating Loss (NOL)
A taxpayer has an NOL when business deductions exceed business income.
Common sources:
- Trade or business losses
- Casualty/theft losses
- Rental losses
- Military moving expenses
NOLs:
- Carry forward indefinitely
- Are limited to 80% of taxable income (post‑2017 rules)
Pre‑2018 NOLs follow old rules (2‑year carryback, 20‑year carryforward, no 80% limit).
Items Not Allowed in NOL Calculation
- Capital losses exceeding capital gains
- Section 1202 exclusion
- Non‑business deductions exceeding non‑business income
- NOL deduction itself
NOLs are reported on Schedule 1 as negative income. A statement must be attached showing the computation.