What is an Ordinary Loss?
An ordinary loss is a loss recorded in a taxpayer’s books that is allowable as a deduction against ordinary income for income tax purposes. It often arises from the sale of inventory, business operations, or other ordinary transactions. The benefit of ordinary losses is that they are entirely deductible in the current year, making them preferable to capital losses, which have limitations on deductibility.
For instance, if a company sells its inventory at a loss, this loss is considered an ordinary loss and can be deducted fully against the company’s ordinary income. In contrast, if the loss comes from the sale of an investment, it is classified as a capital loss and may have restrictions on the amount that can be deducted in a given tax year.
Examples
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Inventory Sale at a Loss: A retail store that sells a bulk of unsellable merchandise at less than its cost price incurs an ordinary loss. This loss can be deducted against the retailer’s ordinary income, potentially reducing the overall taxable income significantly.
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Business Operational Loss: If a construction company suffers a loss due to unforeseen operational issues or failure to collect receivables, this would result in an ordinary loss deductible against their business income.
Frequently Asked Questions (FAQs)
Q1: What distinguishes an ordinary loss from a capital loss?
A1: Ordinary losses result from transactions like the sale of inventory or business operations and are fully deductible against ordinary income in the current year. In contrast, capital losses stem from the sale of investments or assets, and their deductibility is usually limited to $3,000 a year against ordinary income after offsetting capital gains.
Q2: Can all business losses be classified as ordinary losses?
A2: No, not all business losses are classified as ordinary losses. Losses from the sale of investments, for instance, are considered capital losses. Only losses from sales of inventory, business operations, or other routine business activities fall under ordinary losses.
Q3: Are there any restrictions on deducting ordinary losses?
A3: Generally, there are no restrictions on deducting ordinary losses in the current year. However, they are subject to the standard rules, such as substantiating the loss and not deducting it if it exceeds certain amounts without appropriate documentation and justification.
Q4: How do ordinary losses impact a company’s tax returns?
A4: Ordinary losses directly reduce a company’s ordinary income, leading to a lower taxable income and consequently reducing the tax liability significantly more than a capital loss would.
Q5: Can an individual taxpayer claim a business ordinary loss?
A5: Yes, individual taxpayers who have business income and incur business losses can claim those ordinary losses on their tax returns, similar to corporations.
Related Terms
- Ordinary Income: The income earned from providing services or selling physical goods/products such as wages, salaries, tips, commissions, and ordinary business income.
- Capital Loss: A loss incurred from the sale of investments or assets, which is subject to limitations on the amount that can be deducted in a tax year.
- Tax Deduction: An expenditure that can be subtracted from gross income to reduce the total amount subject to taxation.
- Inventory: The raw materials, work-in-process goods, and completely finished goods that are considered part of a business’s assets that are ready or will be ready for sale.
Online Resources
- IRS: Casualty, Disaster, and Theft Losses
- TurboTax: Tax Deductions and Credits
- Investopedia: Tax Loss Carryforward Definition
References
- U.S. Internal Revenue Service (IRS) Publications
- Publication 544 (Sales and Other Disposition of Assets)
- Publication 925 (Passive Activity and At-Risk Rules)
Suggested Books for Further Studies
- “Principles of Taxation for Business and Investment Planning” by Sally Jones and Shelley Rhoades-Catanach
- “Federal Income Taxation” by Joseph Bankman
- “J.K. Lasser’s Small Business Taxes 2023: Your Complete Guide to a Better Bottom Line” by Barbara Weltman
