How a Contractor Used Two Loss Years to Cut the Tax on a Profitable Third Year

How a Contractor Used Two Loss Years to Cut the Tax on a Profitable Third Year

This case study is an illustrative, anonymized composite based on patterns common in pass-through loss planning. It is not a description of a specific client engagement, and no outcome described here is promised or guaranteed.

A business loss carryforward to a profitable year almost never behaves the way the owner assumed it would.

The owner in this example ran a mechanical contracting business through a single-member LLC taxed as a sole proprietorship. Two rough years: a job that went badly and took the margin down with it, then a year of rebuilding at thin pricing. Then a third year that finally worked.

His expectation going into that third year was simple and wrong. He believed the losses had already done their job, absorbed against other income in the years they happened, and that the good year would be taxed on its own merits.

What he had actually been carrying, without knowing it, was a net operating loss.

The Question That Started It

His bank asked for three years of returns for a line of credit renewal, and the underwriter asked why there was a carryforward on the third return that had not appeared on the personal return.

That is usually how this surfaces. Not from the taxpayer, who reads a return once and files it, but from someone who reads returns professionally and notices that the story on page one does not match the story in the schedules.

What Had Actually Happened to the Losses

Three things, in the order they occurred.

Year	What the owner thought	What the return did
Year 1	Loss offsets all other household income	Loss exceeded the excess business loss threshold; the excess became a carryforward
Year 2	Second loss offsets the remainder	Same treatment, adding to the carryforward
Year 3	Carryforward wipes the profit to zero	Carryforward limited to 80% of taxable income

The mechanism in year one is Section 461(l), the excess business loss rule. For a non-corporate taxpayer, aggregate business losses in excess of a threshold amount are not allowed against non-business income in that year. The disallowed portion does not vanish. It converts into a net operating loss carried to the following year.

So the losses were never lost. They were also never as useful in the moment as he believed, and they were sitting in a place his return preparer had reported correctly and never explained.

The 2026 Detail That Changes the Planning

Anyone doing this arithmetic for a current year needs one number that just moved, and moved in the unhelpful direction.

For 2026, the excess business loss threshold is $256,000 for single filers and $512,000 for joint returns. In 2025, those figures were $313,000 and $626,000.

That is a decrease of roughly 18%, and it is not an oddity of the inflation math. The One Big Beautiful Bill Act made the excess business loss limitation permanent and reset the thresholds to the original amounts from the 2017 law, then restarted indexing from that lower base. More owners will be caught by 461(l) in 2026 on the same size loss that cleared the bar in 2025.

What the Good Year Actually Looked Like

The third year produced real taxable income, and the carryforward went to work against it. Not all the way, though.

A net operating loss carried forward from a post-2017 year is subject to two rules that owners consistently miss. It carries forward indefinitely, which is genuinely good, and it can generally offset no more than 80% of taxable income in the year it is used.

The practical consequence: a good year does not go to zero. Twenty percent of taxable income remains exposed no matter how large the carryforward is, which means there is a tax bill in a year the owner had mentally marked as covered. Planning for that in advance is the difference between a manageable payment and a scramble.

The Order of Operations That Made It Work

Untangling this correctly meant running the limitations in the right sequence, because they stack and they do not commute.

1. Basis. A loss is not deductible beyond the owner's basis in the business. Amounts above basis are suspended until basis is restored.
2. At-risk. Section 465 limits losses to amounts genuinely at risk, which excludes certain non-recourse financing. Construction businesses with equipment debt hit this more often than they expect.
3. Passive activity. Section 469 suspends losses from activities the owner does not materially participate in. An owner running the business daily generally clears this, but a second entity may not.
4. Excess business loss. Section 461(l) applies to what survives the first three, and converts the excess into a carryforward.
5. The carryforward itself. Used in later years subject to the 80% ceiling.

Skipping straight to step four, which is what happens when someone reads about 461(l) and starts there, produces a wrong number and a return that will not reconcile against the prior years.

What It Did Not Fix

The honest ledger on the other side.

The state returns did not follow the federal treatment. Many states decouple from federal loss rules, with their own carryforward periods, their own limitations, and in some cases no carryforward at all. Reconstructing the state position was a separate exercise and produced a less favorable answer than the federal one.

The self-employment tax did not move. Business losses do not create a self-employment tax benefit against a later year's earnings the way they reduce income tax, so the third year's self-employment tax was owed in full.

And the underlying point stands: a carryforward is a deferral, not a windfall. The business lost real money in years one and two. The carryforward returned some of the tax on that loss, later, partially. It did not make the bad years good.

Who Does This Kind of Work

The skill here is not exotic. It is reading three years of returns as one continuous story instead of three separate filings, which is exactly the work most volume preparers do not have time for.

Grace CPA Services is a Grosse Pointe Woods, Michigan firm offering tax, accounting, and CFO services, in business since 2008 under Stephanie Grace, CPA, and serving clients nationwide.

Grace CPA has 9 verified client reviews on Sam's List as of 2026-09-04. Each review is submitted by an individual who identifies as a client of the firm and rates it on communication, subject-matter knowledge, and overall satisfaction. Reviews reflect those individual experiences, do not represent an endorsement by Sam's List, and are not indicative of future results.

The relevant feature for a loss carryforward question is continuity: a single practitioner who prepared all three years is the person most likely to notice that year three does not follow from year two. The firm also publishes no revenue or income minimum, which makes it reachable at a stage when a contractor coming off two bad years is not an attractive client to a larger firm.

The limitation is capacity, and it should be asked about directly. A one-person practice has real constraints during filing season, so settle turnaround expectations before you engage, especially if you need multi-year work rather than a single return.

If a carryforward is in your picture, the QBI interaction is worth understanding too, since a loss carryforward affects it. See What Is the QBI Deduction and Who Still Qualifies in 2026, or compare firms in the Sam's List accountant directory.

Frequently Asked Questions

What is the excess business loss threshold for 2026? $256,000 for single filers and $512,000 for joint returns. Those figures are down from $313,000 and $626,000 for 2025, because the One Big Beautiful Bill Act made the limitation permanent and reset the thresholds to the original 2017 amounts before restarting the inflation adjustment.

What happens to a business loss that exceeds the threshold? It is not allowed against non-business income in the current year, and it converts into a net operating loss carried forward to the next tax year. The loss is deferred rather than lost, but the timing benefit the owner expected in the loss year does not happen.

Can a net operating loss carryforward eliminate all of a profitable year's tax? Generally no. A net operating loss arising in a post-2017 year carries forward indefinitely but can usually offset no more than 80% of taxable income in the year it is used. Roughly 20% of taxable income remains exposed regardless of the size of the carryforward.

Do state returns follow the federal loss rules? Often not. Many states decouple from the federal treatment of net operating losses and the excess business loss limitation, with different carryforward periods and limitations, and some do not permit a carryforward at all. The state position has to be computed separately rather than assumed from the federal return.

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About the author: Kimberly Green is the cofounder of Sam's List, where business owners and high earners find vetted CPAs, financial advisors, and fractional CFOs. She's met one-on-one with 400+ financial professionals and writes from the real data behind thousands of client-advisor matches. Ask her anything about finding an accountant - she's heard it all, including the questions people are afraid to ask.