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 other 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 allowed 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 on $1 million is 35%, and that the janitorial service earns $100,000 per year 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 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 10-year income in taxes, or $250,000, even though both firms earned the same amount of money over the 10-year period.
The American Rescue Plan Act (ARPA), signed into law in March 2021, extends the limitation on excess business losses through tax year 2026 rather than by 2025, as was stipulated by the TCJA. Excess business losses are not deductible but are added to net operating loss. Excess business losses are the excess of business deductions + losses over business income + gains + $250,000.
A NOL is first used to offset income in the year of the NOL, but if the NOL exceeds 80% of the income, then it can be used to offset 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 sole proprietor has a $42,000 NOL in 2020, which is applied to future tax years until the NOL is used up.
|2020 (NOL year)|
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, then 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 a computation showing how the NOL deduction was calculated.
Although most net operating losses are business losses, other losses and deductions also count:
- deduction for ½ 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, the following cannot be used to calculate a net operating loss:
- personal exemptions;
- charitable contributions;
- 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.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, NOLs arising after 2017 will be limited to 80% of income. Additionally, NOLs can no longer be carried back to previous years, but can be carried forward indefinitely.
- allows 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 are 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
- allows the deduction of excess business losses for tax years 2018 through 2020
- temporarily repeals the 80% taxable income limitation for interest for tax years before 2021
- increases the business interest deduction percentage from 30% to 50% for 2019 and 2020
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 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 Schedule A of Form 1045, Application for Tentative Refund. Schedule B of this form is used to calculate the actual amounts to be 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 from modified taxable income, taxable income before nonbusiness deductions exceeding nonbusiness income, personal exemptions, itemized deductions, or the standard deduction is subtracted. Therefore, on Form 1045, 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.
Example: Calculating a NOL on Form 1045
This is an outline of how Form 1045 is used to calculate the NOL. You have a small business with the following income and deductions on your Form 1040.
|Interest on savings||$925|
|Net long-term capital gain on sale of real estate used in business||$12,000|
|Net loss from business||$64,000|
|Net short-term capital loss||$2,500|
Your deductions exceed your income by $82,650 - $62,925 = $19,725, but since some of the deductions are not allowed in calculating the NOL, they must be subtracted from your total deductions on Form 1045, Schedule A to calculate the NOL. These deductions cannot be used to calculate the NOL:
|Nonbusiness net short-term capital losses||$2,500|
|Nonbusiness deductions (standard deduction of $12,200 - nonbusiness income interest of $925)||$11,275|
|Total adjustments to net loss||$13,775|
Therefore, your NOL is:
|Total Income =||$62,925|
|Adjusted Deductions: $82,650 - $13,775 =||- $68,875|
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 intention 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.
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 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, then its NOL cannot be carried forward but it 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 take place after 5 years as an S corporation, unless the IRS permits re-conversion sooner.
The Deduction of Excess Business Losses Is Restricted
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 the use of losses to offset income, by restricting losses to tax 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 further restricted individual taxpayers and 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. Although enacted in 2017, subsequent legislation, enacted because of the Covid-19 pandemic, suspended the excessive business loss limitation provision for 2018 through 2020. However, it will apply for tax years 2021 through 2025, unless the law changes yet again.
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 in the year in which losses occur; the remaining losses may be carried forward as an NOL, when it can be used to offset up to 80% of business income and other forms of income, such as portfolio income.
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 most taxpayers, including estates and trusts, the allowed deduction was initially $250,000, or $500,000 for joint filers. The allowed deduction is adjusted annually for inflation. In 2021, the deductible excessive business loss is $262,000, or $524,000 for joint filers.
So if you are single and earn $1,000,000 of investment income in 2021, but you decide to invest in your business in that same year, creating a $2 million business loss, then $738,000 of your loss will be disallowed. Although your loss is $1 million, your filing status allows you to deduct $262,000 of your loss, leaving $738,000 to be carried forward as an NOL.
Part of the reason why Section 461(l) was enacted was because the TCJA also allowed increased first year expensing, such as allowing a greatly increased §179 deduction, so Congress probably feared that they would lose too much tax revenue without limiting the losses claimable by businesses.
- 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 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 filed.