A net operating loss (NOL) results when a business allowable deductions exceed its gross income for the tax year. It can use the NOL in another year to reduce taxable income. When the NOL is “carried back” to a previous year a refund may result.
While less common, individuals may have an NOL from expenses other than business losses, including:
- Employee business expenses;
- Casualty and theft;
- Moving expenses for a job relocation; and
- Expenses of rental property held for the production of income.
An NOL from another year also cannot be included in the computation, as this would improperly extend the carryover period for that NOL, and could allow the NOL to be counted twice.
Carryback and carryforward periods
An NOL can be carried back 2 years and forward up to 20 years. The NOL must be used in the earliest year available, but, taxpayers can waive the carryback period and irrevocably elect to immediately carry the NOL forward. If the entire NOL from a single year was not completely used in the first year, it may be carried to multiple years. There is no carryback period if the NOL occurs in a corporate taxpayer’s first year.
The carryback and carryforward periods generally cannot be extended, and any NOL remaining after the 20-year carryforward period is lost, except:
- the carryback period is 3 years for any part of an NOL from a casualty or theft;
- from a Presidentially-declared disaster affecting a qualified small business or a business engaged in farming; or
- a farming loss can be carried back 5 years, and a 10-year period is available for a “specified liability loss.”
A “qualified small business” is a sole proprietorship or partnership with average annual gross receipts of $5MM or less for the 2 prior years and the year of the NOL.
A taxpayer may be able to use an expiring NOL in the final year by accelerating the recognition of income.
Election to waive NOL carryback
Taxpayers electing to waive the carryback should attach a statement to their timely filed original tax return for the year the NOL arose. The election to waive the carryback is irrevocable.
Use it or lose it
An NOL is treated as used in a year to which it can be carried, even if the taxpayer did not take the deduction. The NOL is deemed absorbed based on the correct taxable income, which reduces the NOL available in later years.
Claiming the carryback
Both individuals and corporations must file their amended returns within 3 years of the year the NOL was incurred.
Which year tax law applies
The NOL is computed under the tax law that applies to the year in which the NOL is generated, disregarding the law for the year to which the NOL is carried. The NOL deduction allowed in a carryover year is calculated under the law that applies to the year of the deduction.
Effect on different type taxpayers
The starting point for determining whether an individual has an NOL is the line on Form 1040 showing the total of adjusted gross income (“AGI”) reduced by itemized deductions or the standard deduction. If this is a negative number, an NOL may exist, but further computations are required. Individuals are not allowed to take certain deductions to compute an NOL, including: personal exemptions, net capital losses, IRC § 1202 exclusion (50%) from small business stock, and the IRC § 199 domestic production activities deduction.
The NOL is calculated on Schedule A of Form 1045, Application for Tentative Refund (from an NOL or unused general business credit).
If the NOL is carried back, an individual taxpayer can claim a refund using either Form 1045 or Form 1040X, Amended U.S. Individual Income Tax Return. Form 1045 can be used for multiple carryback years, while a separate Form 1040X must be used for each carryback year.
If an individual carries an NOL generated in a year they were not married to a year they were married year, they can only use the NOL to offset the separate income of the spouse who generated the NOL.
Disregarded entities or sole proprietorship
NOLs generated by a disregarded entity (e.g. a single member limited liability company not electing to be taxed as a corporation) or an individual who operates a trade or business as a sole proprietorship are applied at the individual level.
A corporation (that has not elected S status) can deduct its NOL at the entity level. A corporation takes different deductions and modifications to compute its NOL, than an individual taxpayer. Corporations file for a refund with either Form 1120X, Amended U.S. Corporation Income Tax Return, or Form 1139, Corporate Application for Tentative Refund.
Shareholders may not deduct the corporation’s NOLs. NOLs do not automatically flow between the corporation and a successor entity. A C corporation that becomes an S corporation cannot carry over NOLs to the S corporation, thus preventing the C corporation from trying to pass NOLs on to its shareholders.
Partnerships or S corporations
A partnership or S corporation itself cannot use an NOL, But rather, the NOL flows through to the partners or shareholders, who can use the NOL to offset other business and non-business income. The taxpayer (partner or S corporation shareholder) can take the NOL up to the amount of their basis in the partnership or S corporation at the end of the year the NOL is taken, and any NOLs exceeding the basis are carried forward.
Estates and trusts
Estates and trusts can also have NOLs, and should claim any NOL carryback either on Form 1045 or an amended Form 1041, U.S. Income Tax Return for Estates and Trusts.
Cancellation of debt / reducing tax attributes
A taxpayer with cancellation of debt income may exclude the income and reduce its tax attributes, including a NOL or the basis of property. It makes sense to reduce NOLs if they are likely to expire unused. But, an NOL generates more immediate tax savings and can reduce income dollar for dollar in the next year (or a previous year), while basis reduces taxes through depreciation over a number of years (unless non-depreciable such as land) or when the asset is sold in a later year (reducing basis increases gain on disposition).
NOLs belong to the corporation that created them. Trafficking in NOLs occurs when a corporation has more NOLs than it can use, and sells or transfers the NOLs to a profitable corporation in a corporate reorganization or other change of ownership. The IRS and Congress strongly oppose trafficking. The idea is that the NOL should benefit the corporation that suffered the loss, and corporate transactions motivated by NOL trafficking distort the economic benefits of acquiring a business.
A corporation that acquires the corporation’s assets in a nontaxable reorganization succeeds to the NOLs, but IRC § 382 limits the acquiring corporation’s use of NOLs, and the loss allowed to the value of the old NOL corporation’s stock multiplied by the long-term tax-exempt rate. The IRC § 382 limit is increased by recognized built-in gain from appreciated assets of the acquired corporation for assets sold within 5 years after the change of ownership.