A loss carryforward refers to an accounting technique used to apply the current year’s net operating loss (NOL) to future years’ net income, ultimately reducing tax liability.
For example, when a company experiences a negative net operating income (NOI) in one year but enjoys positive NOI in subsequent years, it can leverage the NOL carryforward to mitigate taxable income in profitable years. This reduction translates to lower tax payments, significantly aiding the company’s financial health.
Key Takeaways
- Loss carryforwards enable businesses to extend a current year’s net operating loss (NOL) over future years of positive net income (NOI) to lower future tax liabilities.
- The Tax Cuts and Jobs Act (TCJA) eliminated the two-year carryback option, indefinitely extended the 20-year carryforward, and capped carryforwards at 80% of net income in any given future year.
- Net operating losses originating from tax years beginning before January 1, 2018, remain subject to older carryforward limitations.
Navigating the Rules for Loss Carryforwards
Before the implementation of the Tax Cuts and Jobs Act (TCJA) in 2018, the Internal Revenue Service (IRS) permitted businesses to carry forward NOLs for up to 20 years to offset future profits, or carry them back two years for immediate tax refunds. Post 20 years, any unused losses would expire.
With the advent of the TCJA, the two-year carryback has been removed for most, apart from specified farming losses, and carryforwards now enjoy an indefinite timeframe. However, the usage of carryforwards is restricted to 80% of net income each future year. Notably, NOLs generated before January 1, 2018, remain subject to the former rules and expiration conditions.
NOL carryforwards appear as assets on the balance sheet, presenting deferred tax benefits for potentially substantial tax savings. Creation of a deferred tax asset through NOL carryforwards mitigates net income in succeeding years, with the reduction bounded to 80% of net income each year until depleted.
Initially legislated in the Revenue Act of 1918, this federal income tax provision was a temporary war-related benefit. Over time, the provision’s continuity has fluctuated, reflecting tax policies’ adapting suits of primarily cyclical businesses.
Maximizing the Value of Loss Carryforwards
Businesses should promptly claim NOL carryforwards to maximize value. With losses unadjusted for inflation, earlier claims safeguard greater tax benefits.
For example, if a business encounters a loss of $100,000 in the current year, earlier claims within the 20-year span yield greater financial impact. Due to inflation, the diminished purchasing power over the years would otherwise reduce its claimed value.
Illustrative Example: Using a Loss Carryforward
Consider a company losing $5 million one year but earning $6 million the following year. Given a carryforward limit of 80%, the entity can carry $4.8 million into the succeeding year’s balance sheet, noted as a deferred tax asset. Using this as an expense against income lowers the company’s taxable income from $6 million to $1.2 million, while $200,000 remains in the deferred tax asset account for future years.
How Long Can Businesses Carry Forward Losses?
Businesses can extend losses forward over a span of 20 years, with a ceiling defined as 80% of each future year’s net income.
What Proportion of Losses Are Usable in a Carryforward?
A company can write off up to 80% of each subsequent year’s net income via carryforwards. For instance, a $10 million loss from one year can translate to a $9.6 million offset against future profitability, effectively reducing taxable income substantially.
Loss Carryforward vs. Loss Carryback
Loss carryforwards allow offsetting future taxable income with past year losses, carried over up to 20 years, thus lowering future tax burdens. Conversely, loss carrybacks retroactively apply past losses to prior tax years, yielding immediate tax refunds.
Conclusion
Using the carryforward tax provision strategically can substantially lower a business’s tax burden when they face losses. It is advantageous to apply these losses sooner to counteract inflation’s diminishing return effects.
Related Terms: tax liability, net operating loss, deferred tax assets, Tax Cuts and Jobs Act, loss carryback
References
- Internal Revenue Service. “Treasury Department and IRS issue guidance for consolidated groups regarding net operating losses”.
- The Wall Street Journal. “An Explainer on the Tax Benefit Donald Trump May Have Used”.
