What is NOL?

Net operating loss occurs when a business’s deductions exceed its taxable income or adjustable gross income; in other words, when it hasn’t been making enough profit. Depending on how much of a loss it sustains, the business can benefit from the negative income for a prolonged period of time until it becomes profitable again.

How net operating loss works and what’s excluded

NOL helps organizations to offset their income and reduce their taxes. However, instead of claiming these deductions all at once, businesses can choose to use some and save the rest until they need to decrease their bill in a future tax year. This helps companies who have more cyclical businesses to get some tax relief.

NOL can only work for sole proprietorships and single-member LLCs, because these are pass-through entities, where the business owners must take losses through their personal tax returns. The trick is that while multi-owner LLCs and partnerships cannot claim these types of business losses, the individual members, partners and shareholders of the corporation can claim them. With the distributive share mechanism, these individuals can take responsibility for their share of the business.

While business losses are the main type of net operating losses, there are others that can count, including:

• Casualty and theft losses such as personal property lost during a qualified natural disaster, income-producing property and business property
• Litigation expenses related to the business’s state or federal taxes
• Small Business Investment Company stock losses
• Half of the self-employment tax

However, other items, such as IRA or 401K contributions, alimony/palimony payments or charity contributions, cannot be used. Net operating losses from a previous year are also ineligible; you can’t use the same NOL twice.

Carrybacks, carryforwards and the CARES Act

Carrying forward business loss

Also known as a carryover, a tax loss carryforward is one of the most common ways businesses use NOL to facilitate future tax relief.Businesses that experience NOL in the first year can essentially put more money in their pockets in year two and beyond. The company’s general ledger registers the carryforward as an asset – specifically, as a deferred tax asset that can be used as an offset mechanism.

Before the Tax Cuts and Jobs Act, businesses could carry their losses forward for 20 years, after which any unused losses would expire. Losses originating after January 1, 2018 can be carried forward indefinitely but are limited to a maximum of 80% of the upcoming year’s net income. The 20-year rule still applies for losses that began prior to 2018.

Under current rules, if a business earns $8 million in its first year and $10 million in its second, its taxable income in year two could be just $2 million. However, it may be the case that the business chooses to carry forward portions of that net loss over the next few tax years.

Changes to loss carryback rules

Before TCJA, businesses were able to apply their net operating loss to the returns for up to two years prior. The principle behind this had to do with the time value of money, which states that present money is more valuable than future money. Applying the carryback meant that business owners could receive an immediate refund.

Carrybacks are no longer allowed except for farming and non-life insurance organizations. Both have the two-year maximum for carrybacks, but non-life insurance companies also have the 20-year carryforward without the 80% limitation.

CARES Act

Due to the devastation brought on by Covid-19, the Department of Treasury had to come up with something to help businesses achieve some liquidity. The Coronavirus Aid, Relief, and Economic Security Act suspends the limitations and reinstates NOLs between December 31, 2017 and January 1, 2021 and can be carried back for up to five years. It also removed the 80% carryforward limit, though this limitation resumed for tax years after 2020. Real estate investment trusts and life insurance companies have their own special carryback rules under CARES. Multinational corporations with other tax attributes should pay special attention to how they can integrate the IRS tax codes when it comes to carrybacks or carryforwards and the CARES Act. This means that corporate taxpayers need to understand how certain attributes, such as foreign tax credits, impact their computations.

Information needed to perform NOL calculations

Calculating net operating loss is a simple mathematical equation: adjusted gross income minus expenses. If the result is negative, then it’s considered a loss. However, when it comes to determining eligibility as per the IRS, the process requires some preparation.

In addition to your 1040 form, you may also need:

• Schedule D (Form 1040), which lists your capital gains and losses. When it comes to capital gains and losses, there are special rules that apply to real estate, tax-free exchanges, or stock rights when it comes to a deferred-tax disposition.
• Publication 536, which is the NOL worksheet for individuals, estates and trusts. This provides insight into the details of what counts, what doesn’t and how it can be applied.
• Schedule C (Form 1040), which is for business income generated as a sole proprietor or as a professional.
• Schedule K-1, which covers partnerships or multi-owner LLCs used to report each individual’s earnings, losses, deductions and credits.

Determining and calculating NOL can be complicated, especially when dealing with today’s rapidly changing financial landscape. When considering how your business can benefit from net operating losses, consult a tax professional.