What Is Net Operating Loss (NOL)?
A net operating loss (NOL) occurs when a company’s allowable deductions exceed its taxable income within a tax period. The NOL can generally be used to offset a company’s tax payments in other tax periods through an Internal Revenue Service (IRS) tax provision called a loss carryforward.
NOL tax laws have undergone significant changes in recent years. Net operating losses in 2021 or later may not be carried back, and NOL carryforwards are limited to 80% of the taxable income in any one tax period.
Key Takeaways
- A net operating loss exists if a company’s deductions exceed taxable income.
- An NOL can benefit a company by reducing taxable income in future tax years.
- The Tax Cuts and Jobs Act (TCJA) made significant changes to NOL rules.
- NOLs may now be carried forward indefinitely until the loss is fully recovered, but they are limited to 80% of the taxable income in any one tax period.
- The Coronavirus Aid, Relief, and Economic Security (CARES) Act removed the restrictions on tax loss carryback for tax years 2018, 2019, and 2020.
- Net operating losses in 2021 or later may not be carried back and must be carried forward indefinitely.
How a Net Operating Loss (NOL) Works
A net operating loss is a tax attribute that can be carried forward to offset taxable income in future years to reduce a company’s futuretax liability. The purpose behind this tax provision is to allow some form of tax relief when a company loses money in a tax period. The IRS recognizes that some companies’ business profits are cyclical in nature and not in line with a standard tax year.
NOL carryforwards are recorded as anasseton the company’sgeneral ledger. They offer a benefit to the company in the form of future tax liability savings. A deferred tax asset is created for the NOL carryforward, which is offset against net income in future years. The deferred tax asset account is drawn down each year, not to exceed 80% of net income in any one of the subsequent years, until the balance is exhausted.
A farming business, for example, may have significant profits and a large tax payment in one year, then incur an NOL in the next, followed by another profitable year. To smooth the tax burden, the loss carryforward provision allows for the NOL in the second year to offset taxes due in the third year.
How to Calculate Net Operating Loss (NOL)
Net operating loss is calculated by subtractingallowable taxdeductions from taxable income.
If the resulting figure is negative, there’s a net operating loss. When this happens, the business can carry some of its tax deductions forward to years when it has a profit.
A net operating loss, sometimes called a net loss, appears on the company’s bottom line or income statement.
Net Operating Loss (NOL) Tax Law Changes
Net operating loss has been subject to several tax law changes over the past few years.
Before the implementation of theTax Cuts and Jobs Act (TCJA)in 2018, theIRS allowed businesses to carry net operating losses forward 20 years to net against future profits and backward two years for an immediate refund of previous taxes paid. Because the time value of money shows that tax savings in the present are more valuable than in the future, the carryback method was generally used first, followed by the carryforward method. After carrying losses forward for 20 years, any remaining losses expired and could no longer be used to reduce taxable income.
Tax Cuts and Jobs Act (TCJA)
In 2017, the Tax Cuts and Jobs Act (TCJA) made significant changes to the laws regarding net operating losses. The TCJA removed the two-year carryback provision for tax years beginning Jan. 1, 2018, or later, except for certain farming losses, but allowed for an indefinite carryforward period. However, the carryforwards are now limited to 80% of each subsequent year’s net income. If a business creates NOLs in more than one year, they are to be drawn down completely in the order that they were incurred before drawing down another NOL.
Coronavirus Aid, Relief, and Economic Security (CARES) Act
The Coronavirus Aid, Relief, and Economic Security (CARES) Act effectively suspended the changes made by the TCJA. The pandemic relief bill allowed NOLs arising in tax years beginning in 2018, 2019, and 2020 to be carried back for a period of five years and carried forward indefinitely. However, those special exceptions have now expired.
Losses originating in tax years beginning before Jan. 1, 2018, are still subject to the former tax rules. Any remaining losses will expire after 20 years.
Net Operating Loss (NOL) Carryforward Example
Imagine a company that had an NOL of $5 million one year and a taxable income of $6 million the next. The carryover limit of 80% of $6 million is $4.8 million.
The full loss from the first year can be carried forward on thebalance sheetto the second year as a deferred tax asset. The loss, limited to 80% of income in the second year, can then be used in the second year as an expense on theincome statement. It lowers net income, and therefore the taxable income, for the second year to $1.2 million ($6 million - $4.8 million). A $200,000 deferred tax asset will remain on the balance sheet to be carried into the third year.
Net Operating Loss (NOL) Carryforward Limitations
A net operating loss is a valuable asset because it can lower a company’s future taxable income. For this reason, the IRS restricts using an acquired company simply for its NOL’s tax benefits.
Section 382 of the Internal Revenue Code states that if a company with an NOL has at least a 50% ownership change, the acquiring company may use only part of the NOL in each concurrent year. However, purchasing a business with a substantial NOL may mean a larger sum of money going to the acquired company’s shareholders than if the acquired company possessed a smaller NOL.
What is a net operating loss (NOL) carryforward?
The net operating loss can generally be used to offset a company’s tax payments in other tax periods through an Internal Revenue Service (IRS) tax provision called a loss carryforward. This offers a benefit to a company in that it can reduce a company’s future tax liability by offsetting taxable income in future years. The purpose behind this tax provision is to allow some form of tax relief when a company loses money in a tax period.
How did the Tax Cuts and Jobs Act (TCJA) affect NOL carryforwards?
For tax years 2018 and later, the Tax Cuts and Jobs Act (TCJA) removed the previously allowed two-year carryback provision, except for certain farming losses, but allowed for an indefinite carryforward period. The carryforwards are now limited to 80% of each subsequent year’s net income. If a business creates NOLs in more than one year, they are to be drawn down completely in the order in which they were incurred before drawing down another NOL. The Coronavirus Aid, Relief, and Economic Security (CARES) Act suspended the changes made by the TCJA for tax years 2018, 2019, and 2020; however, the new rules apply for 2021 and onward.
How are NOL carryforwards accounted for?
NOL carryforwards are recorded as an asset on the company’s general ledger. A deferred tax asset is created for the NOL carryforward, which is offset against net income in future years. The deferred tax asset account is drawn down each year, not to exceed 80% of net income in any one of the subsequent years, until the balance is exhausted.
What is the 80% NOL rule?
The 80% NOL rule was introduced by the Tax Cuts and Jobs Act (TCJA) of 2017 and limits net operating loss carryforwards to 80% of each subsequent year’s net income.
The Bottom Line
Posting a loss is never a good thing. However, there is at least one positive to take from it: It’s possible to use a loss to offset taxable income in future years in a process called loss carryforward.
There are some limitations, though. From the 2021 tax year, you can no longer carry back a loss from one year to a previous year. Moreover, carryforwards are now limited to 80% of each subsequent year’s net income.
