Introduction: When a Net Operating Loss Actually Crosses the Atlantic
A net operating loss generated by your British business rarely arrives on your American return in the shape you expect, and in a bad trading year that gap between expectation and reality costs wealthy founders a great deal of money. Furthermore, the 2026 rules changed in ways that most published guidance has not caught up with. The One Big Beautiful Bill Act made the excess business loss limitation permanent and reset its thresholds downwards, while the Internal Revenue Service replaced the old worksheets with an entirely new form.
At TaxYork, we prepare loss-year returns for company owners, founders and investment professionals across London and the wider United Kingdom. Moreover, we see one misconception more than any other: the assumption that a loss in a British business automatically shelters American income. Often it does not reach the US return at all. Additionally, when it does, it can quietly destroy foreign tax credits in later profitable years. This guide sets out exactly what happens, using current 2026 figures and primary sources.
What a Net Operating Loss Is Under US Law
A net operating loss arises under section 172 when your allowable deductions for the year exceed your gross income, computed with specific modifications. Critically, it is a personal-level concept for individuals, estates and trusts. Therefore, the loss must first belong to you as a taxpayer before section 172 has anything to work on.
That sequencing matters enormously for cross-border filers. Specifically, a British business can lose a fortune without ever producing a net operating loss on your Form 1040. Consequently, the first question is never how to compute the loss. Instead, it is whether the loss is yours at all.
Why the Legal Form of Your British Business Decides Everything
The answer turns entirely on how your UK enterprise is classified for American tax purposes. Notably, the same commercial venture can produce a fully deductible net operating loss, a completely trapped loss, or something in between, depending on a structural choice you may have made years ago without advice.
We therefore begin with entity classification rather than with arithmetic. Ultimately, the calculation only becomes relevant once the loss has cleared that first hurdle.
The Threshold Question: Whose Loss Is It?
Three structures dominate among our clients, and each produces a radically different outcome. Understanding which one you occupy is the single most valuable thing you can take from this article.
A UK Limited Company Loss Stays in the Company
If you trade through a UK limited company, the trading loss belongs to the company and not to you. Consequently, it produces no net operating loss on your personal American return whatsoever, however large the figure in the statutory accounts. The company carries the loss forward against its own future profits under British rules, and your Form 1040 sees nothing.
This surprises founders every year. Furthermore, the position is worse than merely neutral, because the controlled foreign corporation rules treat a loss-making company as producing a tested loss that can be netted against tested income from other companies you own, rather than as a deduction you can use personally. Meanwhile, if you injected capital and the company later fails, your relief comes through a capital loss on the shares, not through section 172. Accordingly, the ordinary deduction most owners assume they have simply does not exist.
Sole Traders, Partnerships and Disregarded Entities
By contrast, if you trade personally as a sole trader, the loss flows straight onto Schedule C and can generate a genuine net operating loss. Likewise, a UK partnership or limited liability partnership generally passes its results through to you, and a single-member entity treated as disregarded produces the same direct result.
These are the structures in which a net operating loss actually becomes available to you personally. However, availability of the net operating loss is only the beginning, because two separate caps then apply before the loss reduces a single dollar of tax. We turn to those shortly. Additionally, partners in UK limited liability partnerships face their own classification questions, which we cover in our analysis of the mixed membership partnership rules.
The Check-the-Box Route and What It Changes
A UK limited company can elect to be treated as a disregarded entity or partnership for American purposes, which converts a trapped corporate loss into a personal net operating loss. Nevertheless, the election is a serious step with lasting consequences, including a deemed liquidation on filing and a five-year lock before you can revoke it.
In our experience, making this election reactively in a loss year rarely works well. Instead, the analysis belongs at formation, when the likely profit profile of the business can be modelled properly against both tax systems.
Computing the Net Operating Loss Under the 2026 Rules
Assuming the loss is genuinely yours, the computation itself has changed. Anyone working from guidance written before 2025 is using a superseded method.
Form 172 Replaced the Publication 536 Worksheets
The Internal Revenue Service now provides Form 172, Net Operating Losses for Individuals, Estates, and Trusts, in place of the worksheets that previously sat inside Publication 536. Part I computes the loss itself, while Part II determines the carryover and modified taxable income for each subsequent year.
Consequently, the net operating loss calculation that used to live on an unfiled worksheet now sits on a numbered form with its own published instructions. Furthermore, that shift raises the practical standard of documentation considerably. Filers who previously kept loose schedules should expect the computation to be examined on its own terms.
Nonbusiness Deductions and Nonbusiness Income
The mechanics that trip people up sit in Part I. Specifically, you must add back nonbusiness deductions to the extent they exceed nonbusiness income, because a net operating loss is designed to capture trading losses rather than personal ones. Consequently, the statutory figure and the commercial figure diverge immediately.
For our clients, the nonbusiness side is usually substantial. Notably, investment interest, charitable giving and similar personal items get stripped out, which means the deductible net operating loss is frequently far smaller than the headline trading figure. Additionally, nonbusiness capital losses receive their own separate treatment earlier in the same part.
Where the Deduction Lands on Schedule 1
In a carryforward year, the net operating loss deduction appears as a negative figure on Schedule 1 of Form 1040, in the other income section. Importantly, a net operating loss is not a below-the-line deduction and it does not depend on itemising.
Reporting it correctly matters more than it appears. Specifically, a deduction entered in the wrong place distorts adjusted gross income, which in turn feeds the foreign tax credit limitation and several phase-outs. Therefore, precision here protects other positions on the same return.
Three Limitations That Apply Before Section 172
Most guidance jumps straight from the trading loss to the net operating loss. In reality, three separate provisions can disallow your loss before section 172 is ever reached, and they apply in a fixed statutory order. Consequently, understanding that sequence is what separates a correct return from an optimistic one.
Basis and the At-Risk Rules Come First
Where your British business runs through a partnership or a limited liability partnership, section 704(d) allows a loss only to the extent of your outside basis in the partnership interest. Any excess suspends until you restore basis, typically through further contributions or allocated profits.
Immediately afterwards, the at-risk rules in section 465 test whether you genuinely bear the economic risk of loss. Notably, non-recourse funding and guarantees from connected parties frequently reduce the at-risk amount below the basis figure. Therefore, a partner can clear the basis test and still find the loss suspended, which is a distinction we spend considerable time explaining to clients each spring.
The Passive Activity Rules Sit Third
Section 469 then asks whether you materially participated in the business. If you did not, the loss becomes a passive loss usable only against passive income, and it suspends until you dispose of the entire interest. Furthermore, this catches American investors holding minority stakes in British trading ventures far more often than they expect.
Only a loss surviving all three tests becomes available to offset other income, and only then do the excess business loss and net operating loss provisions engage. Accordingly, the correct order runs basis, at-risk, passive activity, section 461(l), and finally section 172. Skipping a step almost always overstates the relief. We examine the third of these in detail in our guide to the passive activity loss rules.
The Two Caps That Shrink the Deduction
Even a properly computed net operating loss meets two separate statutory ceilings before it reduces tax. Both have moved recently, and the more important one has changed permanently.
The Section 461(l) Excess Business Loss Limitation
Section 461(l) restricts the amount of net business loss a noncorporate taxpayer may use against nonbusiness income in a single year. For 2026, the threshold is $256,000 for single filers and $512,000 for joint returns, reported on Form 461.
Two changes deserve attention. Firstly, the One Big Beautiful Bill Act removed the sunset date, so the limitation is now permanent law rather than a temporary measure expiring in 2028. Secondly, the thresholds were rebased to $250,000 and $500,000 indexed from 2024 rather than from 2017, which left them materially lower than the previous method would have produced. Consequently, several widely read 2026 guides still describe this limitation as temporary and quote inflated thresholds. They are wrong on both counts.
Anything above the threshold is not lost outright. Instead, the excess converts into a net operating loss carried to the following year, where it immediately meets the second cap.
The Eighty Per Cent Ceiling Under Section 172
A net operating loss arising after 2017 carries forward indefinitely, but the deduction in any later year cannot exceed eighty per cent of taxable income computed without regard to the net operating loss deduction itself, or to the section 199A and section 250 deductions.
Furthermore, the carryback has effectively gone. Generally, losses arising in tax years after 2020 can only be carried forward, with a narrow two-year carryback surviving for farming losses. Therefore, the strategy of throwing a net operating loss back against a profitable prior year, which many older articles still describe, is unavailable to almost every reader of this page.
The Foreign Tax Credit Consequence Nobody Explains
Here sits the most expensive trap in this entire area, and we have never seen a competing guide address it for expatriate business owners. A British trading loss is foreign-source. Accordingly, when your net operating loss offsets American-source income, it creates a liability that surfaces years later.
The Overall Foreign Loss Account
Under section 904(f), a foreign-source loss that reduces United States-source income creates an overall foreign loss account. Subsequently, in each later year with foreign-source income, up to fifty per cent of that foreign income gets recharacterised as American-source until the account is exhausted.
That recharacterisation shrinks the numerator of your foreign tax credit limitation. Consequently, UK tax that you genuinely paid becomes uncreditable, and the relief you enjoyed in the loss year is clawed back through the credit system rather than through the income tax itself. We examine this mechanism in depth in our guide to overall foreign loss recapture.
Why Section 172 Is Expressly Excluded
A technical point of real practical importance follows. Regulation section 1.904(f)-1 provides that in determining the overall foreign loss for a year, net operating loss deductions under section 172(a) are not taken into account.
In other words, the overall foreign loss is measured by reference to the current year's foreign loss rather than by the net operating loss deduction you claim later. Therefore, the two regimes run on different clocks. Additionally, this prevents double counting, but it also means the recapture exposure crystallises in the loss year itself, long before you feel it. Modelling the credit position alongside the deduction is consequently essential rather than optional.
The Foreign Earned Income Exclusion Collision
Most Americans running a business in Britain have claimed the exclusion at some point. In a loss year, that history creates its own difficulties.
Section 911(d)(6) and Disallowed Deductions
Section 911 denies any deduction or credit properly allocable to excluded income. Accordingly, in a year where you exclude earnings under the foreign earned income exclusion, the expenses attributable to that excluded income cannot also generate relief.
The 2026 exclusion stands at $132,900, claimed on Form 2555. However, in a year that produces a net operating loss there is no positive earned income to exclude, so the election delivers nothing at all while continuing to run. Meanwhile, the foreign tax credit on Form 1116 generally serves high earners in Britain far better, as we explain in our analysis of the foreign tax credit carryforward.
Why a Loss Year Is the Wrong Year to Revoke
Revoking the exclusion looks tempting when it is producing no benefit. Nevertheless, revocation triggers a five-year lockout before you may claim it again without the consent of the Internal Revenue Service, and that consent is expensive to obtain.
Therefore, we generally model the following five years before revoking rather than reacting to a single bad trading period. Ultimately, a loss year is precisely when the decision looks most obvious and is most likely to be wrong.
The British Side and the Timing Mismatch
Relief in the United Kingdom follows entirely separate rules, and the interaction produces mismatches that neither system is designed to resolve.
Sideways Relief and the Fifty Thousand Pound Cap
A British sole trader may set a trading loss against general income of the same year or the previous year, known as sideways relief. However, the income tax reliefs cap restricts that claim to the greater of £50,000 or twenty-five per cent of adjusted total income, as HMRC explains in its Business Income Manual.
Importantly, the cap does not apply where the loss is relieved against profits of the same trade. Consequently, carrying forward is unrestricted in amount but restricted in target. The mechanics and claim deadlines appear in the HS227 losses helpsheet.
Company Losses and the Five Million Pound Allowance
Where you trade through a company, British carried-forward losses face their own restriction above a £5 million deductions allowance, with only fifty per cent of profits above that figure available for relief. HMRC guidance on company losses and the published corporation tax rates set out the current position, alongside the terminal and property loss rules.
Furthermore, this is the point at which the American and British answers diverge most sharply. Your company may be sheltering millions in Britain while your Form 1040 recognises nothing whatsoever.
5 April Versus 31 December
The British tax year ends on 5 April and the American year ends on 31 December. Consequently, a single commercial loss is split across two American years and two British years, and the reliefs land in different periods.
Accordingly, a loss relieved in the United Kingdom in 2026/27 may feed an American net operating loss only in 2027, or not at all. Meanwhile, that mismatch can strand foreign tax credits in exactly the way that produces the bunching problem we see in payments on account. Careful apportionment between the two calendars is therefore part of the preparation rather than an afterthought.
Case Study: A London Founder's Loss Year
Consider an American citizen resident in London who trades personally as a consultant, filing as a single taxpayer. During 2026, a failed product line produces a trading loss of $600,000. Meanwhile, he holds a substantial American brokerage account generating $300,000 of dividends and capital gains.
Applying section 461(l) first, only $256,000 of the business loss may offset his nonbusiness income in 2026. Consequently, $44,000 of investment income remains taxable, and the excess business loss of $344,000 converts into a net operating loss carried into 2027 rather than being relieved now. Our client had expected the full $600,000 to wipe out his investment income entirely.
In 2027, the business recovers and produces $500,000 of profit. The eighty per cent ceiling caps his net operating loss deduction at $400,000, so the entire $344,000 carryforward is usable and the cap does not bite. Superficially, therefore, the outcome looks acceptable.
The real damage sits elsewhere. Specifically, the $256,000 of foreign-source loss that offset his American investment income created an overall foreign loss account of the same amount. Therefore, in 2027 up to fifty per cent of his foreign-source income, being $250,000 of the $500,000 profit, gets recharacterised as American-source. That recharacterisation roughly halves his foreign tax credit limitation in a year when he pays UK tax at forty-five per cent on the whole profit.
Consequently, our client saved approximately $94,700 of American tax in 2026 at a thirty-seven per cent marginal rate, then stranded a comparable sum of British tax in 2027 that he could not credit. Above all, the lesson is that a net operating loss claimed without modelling the credit position simply moves the cost forward by a year.
How TaxYork Can Help
We model the loss year and the recovery year together rather than in isolation, because the section 461(l) cap, the eighty per cent ceiling and the overall foreign loss account interact in ways that a single-year calculation cannot reveal. Furthermore, we test whether your British structure is producing a usable net operating loss at all before any computation begins.
Our team prepares the full cross-border position, including US tax return preparation for expats with Schedule C, Form 172, Form 461 and the associated credit claims filed as one coherent package. Additionally, where earlier loss years were prepared incorrectly or returns were never filed, we manage catch-up work through the IRS Streamlined Filing procedures. Clients with British property interests should also read our analysis of the passive activity loss rules, which restrict rental losses on an entirely separate basis, and self-employed readers should review the certificate of coverage position.
Conclusion
A net operating loss is far harder to use across the Atlantic than the domestic guidance suggests. Firstly, a limited company loss never becomes your net operating loss at all. Secondly, even a genuine personal loss meets a $256,000 or $512,000 ceiling in 2026 and an eighty per cent cap thereafter. Thirdly, and most expensively, the net operating loss relief you obtain today creates an overall foreign loss account that erodes your foreign tax credits tomorrow.
Above all, treat the loss year as a planning year rather than a filing exercise. Ultimately, the difference between a well-modelled net operating loss and a mechanically computed one is measured in the credits you keep rather than the deduction you claim. Professional commentary from ICAEW, the AICPA and the Chartered Institute of Taxation tracks developments on both sides, but neither profession publishes the combined answer.
Contact Us
Speak to our cross-border specialists before you file a loss year, not afterwards. You can book a consultation with our team, email hello@taxyork.com, or call 020 3488 8606. Furthermore, we welcome enquiries from founders, company owners and investment professionals who need the American and British loss positions reconciled properly.
Disclaimer
This article provides general information about United States and United Kingdom tax rules and does not constitute professional advice. Tax legislation changes frequently, and the application of these rules depends entirely on your individual circumstances. Accordingly, you should obtain specific professional guidance before acting on anything contained here. TaxYork accepts no liability for any action taken in reliance on this article.
Written by the TaxYork Expert Team — US-UK tax specialists.