It’s probably safe to say that your goal as a business owner is to make money, not lose it. Even if you find yourself on the losing side of the equation, there are situations in which your company might be able to minimize the impact from business losses. A Net Operating Loss (NOL) occurs if a business’s tax-deductible expenses exceed its taxable income in a given year. With proper planning, you might be able to use Net Operating Losses to reduce your business’ tax liability.
It’s important to note that partnerships and S corporations are generally not permitted to use the Net Operating Loss, as they themselves are deemed to be pass-through entities. However, partners and shareholders can use their separate shares of the partnership or S corporation’s business income and business deductions to figure their individual Net Operating Losses.
Complex Rules, Simple Concept
The IRS rules about Net Operating Losses can be complex, but the concept is relatively simple: Net Operating Losses allow businesses to use losses incurred in one year to offset income earned in other years, thereby reducing taxable income and the amount of tax due in those profitable years.
Net Operating Losses can generally be carried back to the prior two tax years, or even the prior three tax years, in certain situations which are mainly limited to casualty or theft losses or other losses attributable to a federally-declared disaster for qualified small businesses or certain qualified farming businesses. (For farming losses, there is a five year carry back period.) Carrying back Net Operating Losses will enable you to recover past tax payments, boosting your current cash flow.
Alternatively, Net Operating Losses can be carried forward up to 20 years. In other words, you can offset income earned in future years with losses your business incurs now. However, the Net Operating Loss must be carried back before it can be carried forward, though the business can elect to waive the carryback period with the filing of their original return if the return is filed by the due date (including extensions) for the Net Operating Loss year.
Should You Carry Net Operating Losses Back or Forward?
So which strategy makes more sense: carrying Net Operating Losses back to offset income in one or both of the prior two years or holding onto Net Operating Losses to possibly offset future income? The answer depends on several different factors.
First, how is your current cash flow? If it’s relatively strong and you don’t necessarily need a cash flow boost in the form of a current tax refund, you might decide to hold onto the Net Operating Loss and save it for the future. Of course, this assumes that you anticipate having profitable years in the future.
But you also should consider the time value of money — in other words, the fact that tax savings realized now are inherently more valuable than those realized in the future. According to this thinking, it’s more beneficial to carry Net Operating Losses back to reduce taxes in prior years and reap the tax benefits right away.
Another factor is whether you expect your business income to increase in future years and, if so, by how much? Higher business income in future years could push your company into a higher tax bracket. This would make Net Operating Losses more valuable in the future because they would be used to offset income that would otherwise be taxed at a higher rate.
Some Net Operating Loss Examples
Here are several examples that help illustrate how Net Operating Losses can save tax dollars for a business:
Example 1. Suppose your company has taxable income of $500,000 and deductible expenses of $700,000 this year. This would result in an Net Operating Loss of $200,000. Two years ago, however, the numbers were reversed: You had taxable income of $700,000 and deductible expenses of $500,000, or a net profit of $200,000. You could carry this year’s $200,000 Net Operating Loss back to offset that year’s $200,000 profit, which would result in no tax due and a refund of the taxes you paid for that year.
Example 2. Now let’s suppose your company had a $100,000 profit two years ago and the same $200,000 Net Operating Loss this year. You could carry back half of your Net Operating Loss to offset that year’s profit, leaving you another $100,000 to carry forward from two years ago to last year.
Example 3. Then imagine you broke even last year. In that case, you’d have $100,000 of the loss available to offset profits in future years. So if your company has a $50,000 profit each of the next two years, these profits could be offset by the remaining $100,000 Net Operating Loss, resulting in no tax due in either of these years.
Tax Reform and Net Operating Losses
With the Trump administration, there’s been a lot of talk about substantive tax reform. It’s still too early to get a good sense of what that reform might look like, including whether it would impact the strategy of using Net Operating Losses to reduce taxes.
So, keep a close eye on tax reform developments going forward and speak with your Untracht Early tax advisor about the possible effect any current legislation may have on this tax-saving strategy.