What it means
A net operating loss, or NOL, occurs when allowable deductions exceed gross income. A business that loses money in a year, such as a start-up in its first year, may produce an NOL.
Instead of that loss being wasted, the tax system lets it be carried to other years to offset profits. The publication explains how to work out the loss, which is not simply the accounting loss.
Certain items are adjusted, such as personal deductions that cannot create a loss and some business and non-business items. The amount is then carried to other tax years in a set order and used against income there.
The carryover rules have changed several times. In recent rules, many losses can be carried forward indefinitely, but the deduction in any year is limited to a percentage of taxable income, which has been 80%.
Carrying losses back to earlier years is allowed only in limited cases, such as certain farming losses, and because Congress can change these limits, the version for the year concerned should be checked. For business owners and advisers, the benefit is planning.
A company that expects a loss this year and profits later can model how much tax it will save in the future, and it can decide how to time income and deductions. Lenders and investors also look at carried-forward losses as a possible future tax shield, although the value depends on future profits.
Records matter. The loss must be tracked year by year, with a record of how much has been used and how much remains.
Mistakes in the schedule can lead to a deduction being disallowed, so many taxpayers rely on software or a tax professional. The publication also helps with planning.
An owner who knows a loss is coming can decide whether to accelerate income or defer deductions, so that the loss is used as fully as possible. Because a very large loss may take many years to absorb, advisers often model several scenarios before choosing a strategy.
In practice
Real-world examples.
Example
A start-up founder who operates as a sole trader loses $90,000 in the first year because of heavy launch costs. She carries the loss forward and uses it to reduce the tax on her profits in the following years.
Example
A farmer suffers losses in a bad harvest year and uses the special rules for farming losses to claim a refund of tax paid in earlier years, subject to the rules that apply. The claim requires a separate calculation and an amended filing.
Example
An investor with rental property and other business activities calculates his net operating loss using the worksheet in the publication. He finds that personal deductions cannot increase the loss, which reduces the amount he can carry over.
Formula
Calculation
Maximum NOL deduction in a year = lower of (NOL available, limit percentage x taxable income before the NOL)
Taxable income after the deduction = taxable income before NOL - NOL deduction
Remaining NOL carried forward = NOL available - NOL deduction
A business owner has a $200,000 net operating loss from a previous year. In the next year, taxable income before the loss is $150,000, and the limit is 80%. The limit equals 0.80 x 150,000 = $120,000. The deduction is the lower of 200,000 and 120,000, which is $120,000. Taxable income after the deduction is 150,000 - 120,000 = $30,000, and the NOL carried forward is 200,000 - 120,000 = $80,000.Case study
Seen in the real world.
Westfield Restaurants is an illustrative, fictional business run as a sole proprietorship. In a year when a long renovation closed the dining room, the owner recorded a loss, and the calculation in the publication gave a net operating loss of $60,000.
In the following year, the restaurant earned $100,000 before using the loss. The owner applied the 80% limit, which is 0.80 x 100,000 = $80,000, and used the full $60,000 loss. Taxable income fell to 100,000 - 60,000 = $40,000.
At a 22% marginal tax rate the tax saving was 60,000 x 0.22 = $13,200. The illustrative lesson is that a loss is not wasted when it is tracked carefully, and the saving can help rebuild cash after a difficult year.
Watch out
Common mistakes.
- Assuming the accounting loss equals the tax net operating loss, when adjustments can change the amount.
- Using an outdated carryover rule, when the permitted carryback, carryforward and percentage limit have changed.
- Failing to keep a running schedule, so the unused balance cannot be proven when it is claimed.
Questions
People also ask.
What is a net operating loss?
It is the amount by which allowable deductions exceed income in a year, which can be used to reduce taxable income in other years.
Can a loss be carried back?
Only in limited cases under the rules in recent years, so check the guidance for the specific year.
Does the publication apply to companies?
It is written for individuals, estates and trusts, and corporations generally use other guidance.
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