Net Operating Loss (NOL) - A net operating loss (NOL) occurs when a company’s allowable deductions exceed its taxable income within a tax period. The NOL can generally be used to offset a company’s tax payments in other tax periods through an IRS tax provision known as a loss carryforward.
Key Points to Consider
- Definition: An NOL exists if a company’s deductions surpass its taxable income.
- Future Focus: NOLs provide a benefit by reducing taxable income in future years.
- Legislation Changes: The Tax Cuts and Jobs Act (TCJA) significantly altered NOL guidelines. For losses from 2021 onward, they are limited to covering 80% of each tax period’s taxable income and can no longer be carried back.
- Relief During Crisis: The CARES Act temporarily adjusted TCJA rules, allowing carrybacks for losses from 2018-2020.
- Indefinite Carryforward: Currently, NOLs can be carried forward indefinitely until fully utilized under these constraints.
Operational Dynamics of NOL
A net operating loss can be carried forward to offset future taxable income, thereby reducing a company’s future tax liabilities. This tax provision provides relief for companies experiencing cyclical profits and losses. NOL carryforwards are tracked as assets on the company’s general ledger. When these carryforwards are utilized, they create deferred tax assets that offset net income in future tax years, though not exceeding 80% of the net income for any given year.
For example, a farming business might alternately see high profits and sizable tax payments followed by losses and NOLs, then return to profitability. Under these conditions, the NOLs can offset the high taxes due in profitable years.
Calculating Net Operating Loss (NOL)
To calculate NOL, subtract allowable tax deductions from taxable income:
- If the result is negative, a net operating loss is present.
- Businesses can carry forward deductions to profitable years for tax benefits.
Recent Tax Law Changes Affecting NOL
Tax Cuts and Jobs Act (TCJA)
In 2017, the TCJA enacted noteworthy changes to NOL regulations. The act stopped the two-year carryback for most losses, allowing for an indefinite carryforward. Future carryforwards, however, can only offset up to 80% of subsequent taxable income.
Coronavirus Aid, Relief, and Economic Security (CARES) Act
The CARES Act, enacted due to the COVID-19 pandemic, temporarily relaxed TCJA restrictions, enabling taxpayers to carry back NOLs generated in 2018-2020 for five years. This flexibility has since expired, and current rules apply from 2021 onwards.
Thoughtful Example of NOL Carryforward
Consider a company with an NOL of $5 million one year and $6 million in taxable income the following year. Given the 80% limit, the company can offset $4.8 million of its loss against the following year’s income. This leaves $1.2 million in taxable income for the second year. The remaining $0.2 million NOL will carry forward into future periods.
Restrictions Under Section 382
Companies cannot use purchased entities simply for their NOL advantages. Under Section 382 of the Internal Revenue Code, if a company with an NOL undergoes a 50% ownership change, the acquiring firm can utilize only part of the NOL yearly. This part-benefit aims to prevent abuse of tax advantages from acquired NOLs.
Further Insights on NOL Provisions
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Loss Carryforward: A mechanism that allows the offsetting of present losses against future income for tax relief.
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TCJA’s Impact: Since 2018, the Act removed the two-year carryback but allowed indefinite carryforward, with an 80% limitation on future offsets.
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Accounting for NOL: NOL carryforwards show as assets on ledgers and create deferred tax assets to be incrementally utilized each year until depleted.
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Key Rule: The 80% NOL rule set by TCJA limits offset capability to up to 80% of following years’ income.
Conclusion
While a net operating loss signals a rough year, there is a silver lining: Through loss carryforward provisions, companies can offset future taxable income and alleviate significant future tax liabilities. Businesses should consider these provisions strategically, mindful of newer legislative limitations to achieve optimal balance and relief in future financial planning.
Related Terms: tax deductions, taxable income, deferred tax asset, IRS, carryforward, carryback
References
- Internal Revenue Service. “Publication 536 (2022), Net Operating Losses (NOLs) for Individuals, Estates, and Trusts”.
- Tax Policy Center. “How Did the Tax Cuts and Jobs Act Change Business Taxes?”
- Internal Revenue Service. “Tax Cuts and Jobs Act: A Comparison for Businesses”.
- Internal Revenue Service. “Tax Reform Changes the Rules About Net Operating Losses”.
- Internal Revenue Service. “Part III—Administrative, Procedural, and Miscellaneous”, Pages 1–2.
