A net operating loss (NOL) occurs when a business’ tax deductions exceed income. Business owners need to learn what a net operating loss is and how it affects their taxes. Essentially, businesses can use an NOL to offset a future tax bill from $100 to $250,000 for up to 20 years.
How a Net Operating Loss Works
Businesses have a net operating loss for many reasons. Some companies struggle in their first year, and expenses exceed income. Other businesses are in a cyclical industry that have bust years followed by boom years. Hard economic times are also a common cause of business losses. For example, many businesses had an NOL during the 2008 recession, which they used as a tax relief when the economy improved.
Tax deductions for a net operating loss were created to give business owners relief from their business losses and tax burdens. If an NOL occurs in your business, you can carry forward the loss for up to 20 years. A carryforward is a tax strategy that involves carrying your current loss forward to apply to a future year’s tax bill.
If you wait more than 20 years to apply the net operating loss, the loss is no longer eligible. It’s important to note that NOL rules are also governed by the state in which your business is registered. For example, Illinois only allows a carryforward for up to 12 years. Kansas and Vermont only allow you to carry forward NOLs for up to 10 years.
Previously, there was an NOL carryback, which was applied similar to a carryforward but only for a maximum of two years. However, the carryback was eliminated in the Tax Cuts and Jobs Act of 2017 (TCJA) and generally can only be applied to losses before January 1, 2018. Carrybacks can be applied to businesses in certain industries or special circumstances, including farming businesses and for disaster relief.
Jared Weitz, the founder and CEO of United Capital Source, iterates what a net operating loss is and how tax laws surrounding it have changed.
“Many people have done it―they leave their high paying executive salary job to start their own business. However, building a profitable business takes time, and the first few years can typically end with a net operating loss. Let’s say, you leave your $250,000 per year job and start a business that ends up with $100,000 in net losses during the first year. Prior to the 2018 tax year, you could take that net loss retroactively and offset a portion of your old high-paying salary in the two years prior. This would have potentially meant you would have received a cash payment from the IRS. From 2018 forward, you can only carry forward losses for future tax benefits.”
―Jared Weitz, Founder & CEO, United Capital Source
Net Operating Loss Carryforward
A net operating loss carryforward is when you deduct the NOL from taxable income on a future year’s tax return. Due to the tax law changes in 2018, most businesses that have an NOL carryforward their net operating losses and don’t carryback. The year you incur a loss is called the NOL year.
During the year you incur the NOL, you’ll need to file a statement with your tax return that indicates you are carrying the loss forward. If you have forgotten to make this statement in a prior year’s tax returns, you can file for an amendment.
NOL Carryforward Example
Let’s walk through a net operating loss carryforward example. In year one, your business has a taxable income of $500,000 and tax deductions of $700,000 with a tax rate of 40%. Your net operating loss for year one would be:
$500,000 (taxable income) – $700,000 (tax deduction) = -$200,000 NOL
You wouldn’t pay any taxes in year one because the business did not earn any profit. In year two, the business income increases to $800,000, and tax deductions are reduced to $600,000. The tax rate remains 40%. Your net operating gain (profit) for year two would be:
$800,000 (taxable income) – $600,000 (tax deduction) = $200,000 profit
$200,000 profit x 40% tax rate = $80,000 in taxes owed
You can use the year one net operating loss of -$200,000 to offset a portion of the year two profit of $200,000. The $80,000 tax bill in year two will be much less. Potentially, the tax bill could be $0.
It’s difficult to say what the final tax bill in year two will be because it varies based on federal laws, state laws, and business jurisdiction. For example, per the TCJA, business owners can only reduce up to 80% of their business’ taxable income; this rule expires in 2025. It’s recommended to contact a tax attorney or certified public accountant (CPA) if you are unsure how to apply the NOL.
Corporations can have an unlimited amount of net operating losses in a given year. However, it’s important to note that net operating losses for individual business owners, such as those with sole proprietorships and limited liability corporations (LLCs), that occurred after 2017 are capped. For individuals, it’s limited to the total amount of income earned from all businesses, plus $250,000―$500,000 for joint filers. Typically, the carryforward for most single taxpayers won’t exceed $250,000.
”If you own a small business with a net operating loss and your spouse has another source of income, you can get a tax break by filing taxes as a married couple. For example, if your spouse earned $100,000 in salary last year, but your sole-proprietorship business had a $30,000 net operating loss, your taxable income would be $70,000 (figures simplified for illustrative purposes). If your tax rate is 33%, you’d be saving $10,000 in taxes. A few thousand dollars is especially helpful when your business is not profitable and you are not able to pay yourself a salary in the early years.
―Ashley Lim, Founder & CEO, Mansa Tea
Purchasing a Business to Carryforward Its NOL
A business that has a net operating loss may be viewed as an asset. If you’re considering purchasing a business to use their NOL to carry forward and offset your business’s future tax burden, use caution. The IRS limits businesses from solely being purchased for their net operating losses. Section 328 of the IRS code says if ownership interest in a business changes by more than 50%, the NOL that can be carryforward is limited.
Net Operating Loss Carryback
The NOL carryback was eliminated in 2018 with the TCJA. You wouldn’t be able to carry back a net operating loss unless the loss occurred in 2017 or prior. There are exceptions to this for farming losses or a unique circumstance, like disaster relief. If you do qualify for a carryback, it is limited to two years.
Who Can Carry Forward a Net Operating Loss
Not all types of businesses can carryforward and deduct a net operating loss from taxable income. It depends on your registered legal entity. Some business entities are allowed to claim an unlimited amount of NOL, others are capped, and some entities can claim none at all.
Here are the NOL carryforward rules for business entities:
- Corporation: An NOL carryforward is allowed, and the amount is unlimited.
- LLC: An NOL carryforward is allowed. However, it is capped at $250,000 for single tax filers and $500,000 for joint tax filers during that year.
- Sole proprietor: An NOL carryforward is allowed; however, it’s capped at $250,000 for single tax filers and $500,000 for joint tax filers.
- Partnership: An NOL carryforward is generally not allowed. Partners can use their separate individual shares of the business income and deductions to figure out their individual NOLs.
- S Corporation (S-corp): An NOL carryforward is generally not allowed. Shareholders can use individual shares of the business income and deductions to figure out their individual NOLs.
If a C corporation (C-corp) turns into an s-corp, none of the NOL carryovers for that year can be used. However, if an S-corp turns into a C-corp, the carryover can be used. If you are interested in changing your business’s legal entity, you can use an online legal service. IncFile is an online legal service that helps create and change business legal entity. Get started today for $49 plus state fees.
Eligible Deductions for Net Operating Losses
Not all businesses are eligible to carry forward a net operating loss. The majority of your deductions (expenses) must be caused by certain sources. It’s important to know what sources are eligible so that you can report an accurate net operating loss and carry it forward on your tax return. The most common source of a business loss is from general business activities.
NOLs are generally be caused by:
- Normal business activities: This is considered a loss from typical business expenses. You might sell fewer products than you expect and have a high inventory cost. You might also hire and train several employees during the year, increasing your expenses.
- Casualty and theft from a disaster: You may have excessive losses if your business is ever affected negatively by a natural disaster. Both physical damage and theft can occur.
- Moving expenses: Your business may move and incur additional expenses that cause an NOL. Additionally, if your business doesn’t operate during the move, your income will decrease.
- Rental property: You may have a rental property or multiple rental properties that are renovated and incur expenses. It’s also possible to have a slow year during which you’re unable to rent out the property as anticipated.
Generally, your NOL wouldn’t include an individual retirement account (IRA) deduction, capital losses that exceed capital gains, deductions from personal exemptions, or a self-employed person’s contribution to a Keogh plan. If your net operating loss is from these expenses, it’s wise to consult with a tax attorney or CPA about what losses are and aren’t eligible for NOL deductions.
It’s important to record all expenses incurred by the business. Many business owners place an emphasis on income. However, with the tax benefits from the net operating loss, you should record as many expenses as possible. If your business’s expenses were largely due to expenses outside of general business activities, it’s important to consult with a tax attorney or CPA to confirm your business is eligible to carry forward the NOL.
“What can one do to take advantage of a net operating loss? If the NOL is from a pass-through entity such as an S-corporation or a partnership, it can be offset by other income such as wages. Don’t have other income? You can create income by converting a traditional IRA to a Roth IRA. If planned carefully, this could eliminate the tax on the conversion providing tax-free distributions at retirement and tax-free growth instead of tax-deferred growth.”
―Dr. Steven J. Weil, President, RMS Accounting
Tracking Your Net Operating Loss
Net operating losses are reported on business tax returns. However, you should use an accounting system to track and determine your NOL before reporting it on your tax return. A profit and loss statement, otherwise known as a P&L or income statement, is a document that measures a company’s income and expenses during a certain time period.
As a business owner, you will either track income and expenses yourself or hire a CPA. You want your monthly P&L statement to accurately reflect your business’s net profit (losses) for the period.
For example, if you missed reporting expenses on your P&L statement, you would either overstate net profits or understate net losses. Understating your net operating loss would cause you to pay more taxes the following year because you’d have a smaller NOL carryforward balance. Additionally, the IRS recommends keeping financial records for three years after the NOL year or the last carryforward year.
QuickBooks Accounting is cloud-based software to help you track your business’s income and expenses. There is no contract to sign up with QuickBooks, and they have month-to-month payment plans. If you’re hiring a bookkeeper or CPA to manage your business’s accounting, we recommend you study and understand P&L statements. This will help you understand better how your business is performing financially and the likelihood of incurring an NOL.
Frequently Asked Questions (FAQs) About What a Net Operating Loss Is
This section includes the most frequently asked questions about a net operating loss. If you don’t see your question, head to our forum, and post your question there. We have a whole team of industry experts who answer questions from small business owners every day.
What is a net operating loss carryover?
A net operating loss carryover is when you take business losses from a certain year and deduct it from a future year’s taxable income. You are only able to reduce taxable income for a given year by 80%. If there is a leftover NOL, it gets rolled over to the next year.
Currently, you are only able to carry forward an NOL year for 20 years. After the 20 years, it expires. You may have heard of a net operating loss carryback. The tax laws changed in 2018 regarding NOL carryback. Currently, it’s only available for farmers or unique circumstances like disaster relief and can be carried back two years. If your NOL occurred in 2017 or prior, you are eligible to carry back your losses for up to two years.
How long can you carry forward a net operating loss?
You can carry forward an NOL for 20 years. However, you need to check your state’s requirements, which may supersede federal tax rules. For example, Illinois only allows a carryforward for 12 years. If any net operating loss that gets carried over isn’t used, it gets rolled over to the next year and continues to do so until the entire NOL is used to offset taxable income.
How long can you carry back a net operating loss?
The NOL carryback rules changed in 2018. Only net operating losses that occurred in 2017 or prior can be carried back. An exception to the new tax rule is farming-related businesses, and businesses affected by natural disasters. They can carryback net operating losses for up to two years.
Is there a net operating loss for individuals?
Individuals can deduct a net operating loss in addition to businesses. For example, let’s say you file taxes jointly with your spouse. If you run a business that has a loss of $10,000, and your spouse earned $40,000, your total taxable income can be reduced down to $30,000. There may be additional factors that affect NOL. It’s recommended to consult with a tax attorney or CPA before applying a net operating loss to your taxable income.
Additionally, if your business’s legal entity is a partnership or S-corp, the net operating loss is based on the individual’s ownership percentage. The NOL is used at the individual level and not within the partnership or S-corp.
Bottom Line
Having a net operating loss is an unfortunate event in business. Sometimes, the cause of the loss is out of your hands, like a disaster, theft, or economic downturn. Regardless of the NOL cause, you can use the loss as tax relief for your business for the next 20 years. A net operating loss carryforward allows you to reduce your taxable income by a substantial amount and roll over year-to-year until it’s eliminated.
Before determining if you have a net operating loss in your business, you need to track income and expenses. QuickBooks accounting manages all financial aspects of your business, including accounts receivable, accounts payable, payroll, and online customer payments. Get started with QuickBooks Accounting today.
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