Net Operating Losses (NOLs)

A net operating loss (NOL) occurs when business deductions exceed business income and it can also occur when certain nonbusiness deductions exceed taxable income for the year. Tax law allows individuals or businesses to carryback NOLs to prior years to claim a refund or to carry forward a loss for no more than 20 years to reduce taxable income in each of the years in which the NOL can be carried. NOLs can be used to offset income by self-employed individuals, professionals, farmers, and other individuals with casualty losses exceeding their income. Partners, members of limited liability companies, and shareholders of S corporations can also claim NOLs that is in proportion to their ownership interest in the business entity.

Tax law allows net operating losses to be deducted because they obviously reduce income, but net operating losses also equalize the taxes of different taxpayers with different types of businesses where income may be highly variable. For instance, compare a hypothetical biotech firm with a janitorial service. Suppose the effective tax rate on $100,000 is 25% and 35% on $1 million, and that the janitorial service earns $100,000 per year for 10 years and the biotech firm earns nothing in the first 2 years but $1 million in the 3rd year, and then earns no income for the remaining 7 years. If the biotech firm could not carryback and carry forward its net operating losses, it would have to pay an effective tax rate of 35%, or $350,000, while the janitorial firm would only have to pay 25% of its ten-year income in taxes, or $250,000, even though both firms earned the same amount of money over the ten-year period.

A NOL is first used to offset income in the year of the NOL, but if the NOL is greater than the income, then it can be used to offset income in other years. Most businesses and individuals can carry back their losses to offset their income in the 2 previous years, but farmers have a carryback period of 5 years. If the NOL is not used up in the previous years, then they can be carried forward to offset income in the future years for up to 20 years. Any NOL remaining after 20 years cannot be deducted. However, the taxpayer can irrevocably elect to forgo the carryback period and use the NOL to offset future income only, which may be judicious if the taxpayer expects to earn more money in the future or if tax rates are anticipated to be higher.

If the taxpayer claimed a NOL on a joint return, then it can be used to offset the joint income. However, if the taxpayer was single when the NOL occurred, then it can only be used to offset his income. If the NOL was claimed on a joint return, but the taxpayer was single or married to someone else, either in the carryback or carryforward periods, then only the portion of the NOL that was used to offset his own income can be used in other years..

The taxpayer should notify the IRS about the NOL deductions by attaching a statement for each claimed NOL showing the pertinent facts about the NOL, including a computation showing how the NOL deduction was calculated.

Although most net operating losses are business losses, a net operating loss can also be incurred because of:

• casualty and theft, even of personal property;
• moving expenses to a new job location;
• deductible employee expenses, such as for travel or work clothing;
• losses on Small Business Investment Company (SBIC) stock and §1244 stock.

However, the following cannot be used to calculate a net operating loss:

• a net operating loss from another year;
• capital losses that are greater than capital gains;
• the portion of nonbusiness deductions that are greater than nonbusiness income plus nonbusiness net capital gain; and
• contributions to an IRA or Keogh plan.

Investors With Operating Losses

Passive activity losses cannot be treated as net operating losses, since they are subject to other rules. If an investor invests in a business but is not active in it, then the investor cannot share in any operating losses of the business. However, if the business goes bankrupt, then the investor can claim a capital loss, which must be offset against other capital losses and up to $3,000 of earned income in any given year. Any unused capital losses can be carried forward indefinitely at the maximum of $3,000 per year for earned income or to offset any capital gains until it is used up or the taxpayer dies. The loss cannot be carried backward.

At-risk rules limit the deductibility of losses to the amount that was actually invested or at risk. The deductible loss must be computed on Form 6198, At-Risk Limitations, with the result being used to compute the tentative refund on Form 1045.

Hobby law rules may also limit the deductibility of business losses.

Calculating and Reporting Net Operating Losses

The net operating loss deduction is computed on Schedule A of Form 1045, Application for Tentative Refund. Schedule B of this form is used to calculate the actual amounts to be carried back or carried forward. Although this form can be attached to the annual tax return, it can be filed separately.

A net operating loss must be deducted before nonbusiness deductions that exceed nonbusiness income, personal exemptions, itemized deductions, or the standard deduction is subtracted from income. Therefore, on Form 1045, these deductions must be added back to determine the result of the net operating loss.

Form 1045 should be filed separately with a copy of the tax return within one year after the end of the tax year. The IRS will either accept or reject the claim within 90 days.

An amended Form 1040X can also be filed to claim the refund for NOLs that have been carried back, but this form must be filed within 3 years after the due date, including extensions, of the tax return containing the NOL.

The net operating loss is reported as Other Income in the Income section of Form 1040 or one of its variants.

Incorporated Business Losses

Whether shareholders of a small business corporation can offset its losses on their own returns depends on whether it is a §1244 corporation or a C corporation.

A corporation can only qualify under §1244 if the total amount of money or property it receives in return for stock was less than $1 million and the corporation passed a resolution stating its intention was to be a §1244 corporation.

A §1244 corporation allows shareholders to take losses on their own return of up to $100,000 in the first year, or $50,000 for married persons filing separately, and $3,000 on subsequent years against ordinary income. Losses above $3,000 can be deducted from capital gains but not ordinary income. Any unused portion can be carried forward.

The taxpayer must file a statement with the IRS claiming the §1244 loss. However, if the IRS finds that the §1244 rules did not apply, then the losses are treated under the unincorporated business loss rules, listed above. Also, the IRS scrutinizes sales of §1244 stock between related parties, which includes not only the immediate family and in-laws, but also other businesses controlled by the taxpayer or his family.

Operating losses cannot be claimed on individual tax returns by shareholders of a C corporation. A corporate net operating loss can only be claimed by the corporation. A corporate NOL can also be carried back to get refunds of corporate income taxes paid, by filing IRS Form 1139, Corporation Application For Tentative Refund. If the prior year's tax return has not been filed, then Form 1138, Extension of Time for Payment of Taxes by Corporation Expecting a Net Operating Loss Carry Back must be used.

Business owners have greater leeway in deducting operating losses than passive investors do. C corporation shareholders can deduct losses on their investment only in the year that the business fails or when they sell their stock. So to give shareholders the maximum tax deduction for possible losses, a small C corporation should issue stock qualified under §1244.

If a corporation files for bankruptcy or is taken over by another corporation through a merger, then all of its net operating losses are extinguished. Its NOLs can no longer be used to offset future income for the buyer or acquirer.