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 C corporations to carry forward a loss indefinitely 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 individuals with casualty losses exceeding their income. Pass-through entities cannot claim NOLs, but partners, members of limited liability companies, and shareholders of S corporations can claim NOLs proportionate 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 types of businesses with highly variable income. For instance, compare a hypothetical biotech firm with a janitorial service. Suppose the effective tax rate on $100,000 is 25% and on $1 million is 35%, and that the janitorial service earns $100,000 annually for 10 years and the biotech firm earns nothing in the first 9 years but $1 million in the last year. If the biotech firm could not carry forward its net operating losses, it must pay an effective tax rate of 35%, or $350,000, while the janitorial firm would only pay 25% of its 10-year income in taxes, or $250,000, even though both firms earned the same amount of money over the 10-year period.

A NOL is first used to offset income in the NOL year, but if the NOL exceeds 80% of the income, it can be used to offset 80% of income in future years. However, a NOL carryforward does not reduce income subject to self-employment tax; only income subject to the marginal tax is reduced.

A NOL can offset joint income on a joint return. However, if the taxpayer was single when the NOL occurred, 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, only the portion of the NOL used to offset his own income can be used in future 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 showing how the NOL deduction was calculated.

Although most net operating losses are business losses, other losses and deductions also count:

• deduction for 1/2 of the self-employment tax;
• state income taxes on business profits;
• interest and litigation expenses related to a business's state or federal income taxes;
• rental property losses;
• losses on the disposition of business real estate or depreciable business property;
• losses on the sale of accounts receivable if using the accrual method;
• casualty and theft;
• deductible employee expenses, such as for travel or work clothing;
• losses on Small Business Investment Company (SBIC) stock and §1244 stock.

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

• personal exemptions;
• charitable contributions;
• alimony;
• standard deduction;
• a net operating loss from another year (otherwise, the previous NOL would be counted twice);
• capital losses exceeding capital gains, because capital losses have other carryover provisions;
• the portion of nonbusiness deductions exceeding nonbusiness income + nonbusiness net capital gain; and
• contributions to an IRA or Keogh plan.

The 2017 Tax Cuts and Jobs Act limits NOLs arising after 2017 to 80% of income. Additionally, NOLs can no longer be carried back to previous years but can be carried forward indefinitely (exception: farmers have a 2-year carryback though they can opt for only the carryforward).

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, 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 annually 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 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, Application for Tentative Refund.

Hobby loss rules may also limit the deductibility of business losses, if the activity is conducted more as a hobby rather than a business, with little regard to profits.

Calculating and Reporting Net Operating Losses

The net operating loss deduction is computed on Form 172, Net Operating Losses (NOLs).

A net operating loss must be deducted from modified taxable income, taxable income before nonbusiness deductions exceeding nonbusiness income, personal exemptions, itemized deductions, or the standard deduction is subtracted. Therefore, these deductions must be added back to determine the result of the net operating loss. Modified taxable income cannot be less than 0. The change in taxable income created by the NOL carryover will change the adjusted gross income (AGI) for that year, which will also affect deductions and other items that depend on AGI.

Form 1045 should be filed separately with a copy of the tax return within 1 year after the end of the tax year. The IRS will either accept or reject the claim within 90 days.

Incorporated Business Losses

Some additional rules apply to calculating NOLs for C corporations. Passive activity losses do not increase NOLs, but the full dividends-received deduction does. As with other businesses, NOLs from previous years are not used to calculate the current year's NOL.

Shareholders of a small business corporation can offset their losses on their own returns if it is a §1244 corporation. A corporation can only qualify under §1244 if the total amount of money or property it received in return for stock was less than $1 million and the corporation passed a resolution stating its intent to be a §1244 corporation.

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

A statement claiming the §1244 loss must be filed with the IRS. However, if the IRS finds that the §1244 rules did not apply, the losses are treated under the unincorporated business loss rules, listed above. Also, the IRS scrutinizes sales of §1244 stock between related parties, including 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.

Business owners have greater leeway to deduct operating losses than passive investors do. C corporation shareholders can deduct losses on their investment only when the business fails or when they sell their stock. So, to give shareholders the maximum deduction for any 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, all its net operating losses are extinguished. Its NOLs can no longer be used to offset future income for the buyer or acquirer. If a C corporation converts to an S corporation, its NOL cannot be carried forward but can be used to offset any built-in capital gains tax on any property that appreciated while held by the C corporation. A NOL can also be used if the S corporation converts back to a C corporation. However, the conversion can only occur after 5 years as an S corporation, unless the IRS permits re-conversion sooner.

The Deduction of Excess Business Losses Is Restricted for Non-Corporations

Prior to the Tax Reform Act of 1986, many wealthy taxpayers reduced or avoided taxes by claiming losses from various activities even when those losses did not significantly reduce income. When losses exceeded income, a net operating loss was created that could be carried back for 2 years to claim a refund or could be carried forward for up to 20 years to reduce future income. Many tax shelters in the 1970s and the 1980s took full advantage of these loopholes. Subsequent changes in the tax law have removed provisions allowing using losses to offset income, by restricting losses to the taxpayer's adjusted basis, by not allowing losses from investments that were not at risk, and by limiting passive losses to passive income. However, until 2021, businesses could use losses from business activity to offset other forms of income, including wages and portfolio income.

The Tax Cuts and Jobs Act (TCJA), by enacting Section 461(l), has restricted individuals and members of pass-through entities, but not C corporations, from using losses to offset taxable income by disallowing excessive business losses from being deducted from other forms of income. This excessive business loss provision also applies to estates and trusts. This limit on business losses applies for tax years 2021 through 2028 unless the law changes yet again.

The excess business loss limitation is calculated on Form 461, Limitation on Business Losses. Section 461 does allow some excessive business loss to be deducted, based on filing status. For noncorporate taxpayers, including estates and trusts, the allowed deduction is based on filing status and taxable income, adjusted for inflation (updates can be found in Instructions for Form 461).

The excess business loss provision only applies after all other restrictions to deducting losses from gains are applied, including the at-risk and the passive activity limitations and any previous NOLs being carried forward. Furthermore, the excessive business loss provision only applies when the losses occur; the remaining losses may be carried forward as an NOL to offset up to 80% of business income and other forms of income, such as portfolio income, in future years.

Deductions must be totaled even if they are disallowed by some other tax rule, but do not include net operating losses or the 20% business income deduction when figuring the excess business loss. Passive activity rules must be applied before calculating the losses. However, capital losses are not included when figuring deductions. Excess business losses are not deductible but are added to any net operating loss.

Capitals gains are limited to the lesser of:

• net income from gains and losses attributable to a trade or business
• or net capital gain

• Excess business losses
  • = (business deductions + losses)
  • − (business income + gains + threshold amount).

The excess business loss threshold is adjusted annually for inflation. For married filing jointly, the threshold is doubled:

• 2025: $313,000 ($626,000)
• 2024: $305,000 ($610,000)
• 2003: $289,000 ($578,000)

Part of the reason why Section 461(l) was enacted was because the TCJA also allowed increased first year expensing, by greatly increasing the §179 deduction, so Congress probably feared that they would lose too much tax revenue without limiting the losses claimable by businesses.

Notes

Business losses claimed on your personal tax return cannot exceed your tax basis in your pass-through entity.

Historical Notes

The Coronavirus Aid, Relief, and Economic Security (CARES) Act:

• allowed an NOL incurred during tax years 2018 - 2020 to be carried back 5 years before the year of the loss
• for tax years after 2020, NOLs were figured by adding NOLs carried over from before 2018 to the lesser of
  • aggregate NOLs from tax years after 2017 or
  • 80% of excess taxable income
• allowed the deduction of excess business losses for tax years 2018 through 2020
• temporarily repealed the 80% taxable income limit for interest for tax years before 2021
• increased the business interest deduction percentage from 30% to 50% for 2019 and 2020

Before 2018

• NOLs could be carried backward for 2 years or carried forward for 20 years.
• An amended Form 1040X can also be filed to claim a refund for NOLs carried back, but this form must be filed within 3 years after the due date, including extensions, of the tax return containing the NOL.
• Personal service corporations (PSC) cannot carry back a NOL to any year in which the PSC opted out of using a required year under IRC §444.
• 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 was not filed, then Form 1138, Extension of Time for Payment of Taxes by Corporation Expecting a Net Operating Loss Carry Back must be filed.