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Business owners are familiar with the term “Net Operating Loss” or more commonly knowns as NOL, even if they were never in that position, mostly because a loss from operating a business is the most common reason for an NOL.
A net operating loss may be defined as a loss taken in a period where a company's allowable tax deductions are greater than its taxable income.
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In fact, you don’t have to be a business owner to have an NOL. Individuals may have an NOL from casualty and theft losses due to an event that's been declared a disaster by the U.S. president, or loss from rental real estate, royalties, partnerships, S corporations, estates, and trusts.
Small companies may have an NOL because of poor sales, increased expenses or mismanagement of resources.
Although partnerships and S corporations generally cannot use an NOL, partners or shareholders can use their separate shares of the partnership's or S corporation's business income and business deductions to figure their individual NOLs.
In any case, from the taxation point of view, if your deductions for the year are more than your income for the year, you may have a net operating loss.
To determine if you have an NOL, you start with your adjusted gross income (AGI) on your tax return for the year reduced by your itemized deductions or standard deduction (but not your personal exemption). This must be a negative number, otherwise there is no NOL for the year.
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Your AGI already includes all the deductions you have for your losses. You then add back to this amount any nonbusiness deductions you have that exceed your nonbusiness income. These include the standard deduction or itemized deductions, deduction for the personal exemption (eliminated as of January 2018), nonbusiness capital losses, IRA contributions, and charitable contributions. If the result is still a negative number, then you actually have a net operating loss for the year.
Generally, an NOL may be considered a valuable asset because it can lower a company’s amount of taxable income.
Whatever the cause of the loss, the value of the tax credit cannot be used to receive a tax refund, therefore provisions were put in place to allow the carryforward of net operating losses and, up to January 2018, the carryback of an NOL.
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In the past, NOLs were able to offset 100% of taxable income. Business owners could “carry a loss back” meaning they could apply an NOL to past tax years by filing an application for refund or amended return. This enabled them to get a refund for all or part of the taxes they paid in past years. NOLs could generally be carried back two years.
If there was any leftover NOL after the carryback period, you could carryforward the balance up to 20 years after the NOL year. You could also take the option of waiving the two-year carryback period and use the NOL for the carryforward period only.
NOLs created in tax years beginning before January 1, 2018 are subject to the old rules. NOLs generated in tax years beginning after December 31, 2017 are subject to the new rules.
The Tax Cuts and Jobs Act (TCJA) has eliminated carrybacks for NOLs. Starting in 2018, an NOL may only be deducted against the current year’s taxes. However, a two-year carryback continues to apply for certain losses incurred by farming businesses.
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Companies may no longer carry back NOLs to receive refunds for taxes paid in the previous two years. This might very well hinder the restructuring efforts of many companies that can no longer rely on tax refunds generated from the NOL carryback.
Moreover, the TCJA permits taxpayers to deduct NOLs only up to 80% of taxable income for the year (not counting the NOL deduction). Any unused NOL amounts may be carried forward and deducted in any number of future years.
Both the repeal of carrybacks and the 80% limitation, by deferring more of the loss recognition to future years, will generally have the effect of increasing the present value of total federal income taxes owed. Remember, losses are not indexed with inflation, and as a result, each year the claim effectively becomes smaller.
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The TCJA also modified existing tax law on excess business losses by limiting losses from all types of business for noncorporate taxpayers.
An excess business loss is the amount by which the total deductions from all trades or businesses exceed a taxpayer’s total gross income and gains from those trades or businesses, plus $250,000, or $500,000 for a joint return.
Excess business losses that are disallowed are treated as a net operating loss carryover to the following taxable year.
The interplay of the new excess loss rules and other existing rules such as the passive activity is also to be noted. |
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Prior to the enactment of the excess business loss limitation, passive activity losses generated by the taxpayer were limited to the extent of passive income. The passive activity loss limitation remains in effect, however the excess business loss limitation imposes an additional restriction after the passive activity rules are applied.
For purposes of the excess business loss limitation, a non-passive activity is a trade or business activity in which the taxpayer owns an interest and materially participates in the activity. Internal Revenue Code (IRC). Section 469 defines “material participation” as an activity in which the taxpayer is involved in the operation on a regular, continuous and substantial basis.
For tax years beginning before January 1, 2018, losses from a non-passive business were allowed to offset other sources of income without restriction.
For tax years beginning January 1, 2018 through December 31, 2025, excess business losses of a taxpayer other than a corporation are not deductible.
An “excess business loss” is any net business loss from all activities greater than the threshold amount, which is $250,000 for single filers and $500,000 for married couples filing a joint tax return.
If a business is owned through a multi-member LLC taxed as a partnership, partnership, or S corporation, the $250,000/$500,000 limit applies to each owners’ or members’ share of the entity’s losses.
Unused losses may be deducted in any number of future years as part of the taxpayer's net operating loss carryforward. This limitation takes effect in 2018 and is scheduled to last through 2025. |
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| Rules and regulations under the tax law have always been complex and complicated, but when changes come into play as well, help from a tax professional becomes not just advisable, but necessary. |
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