What Is a Net Operating Loss (NOL)?
If you've just started a business, you may not be turning a profit yet. This is normal. It generally takes two to three years for a startup to attain profitability (although it's important to note that different companies measure profitability differently). As an early-stage startup owner who may not yet be earning big bucks, it's essential to know about net operating loss (NOL).
NOL refers to a scenario in which a company's permitted deductions are greater than its taxable income within a given tax period. For income tax purposes, business owners can use NOL to offset their company's tax obligations in other tax periods. This is allowed thanks to something called "net operating loss carryforward," a tax relief provision created by the Internal Revenue Service (IRS) to support early-stage small business owners. If you've been in business for a few years, you may alternatively benefit from a "net operating loss carryback" to receive a tax refund — however, this option is more restrictive, as we'll explain below.
This guide provides a quick introduction to NOL, explaining what it is, how it's calculated, and what the eligibility requirements are.
What Is a Net Operating Loss Deduction?
The term "net operating loss" technically refers to a type of tax credit provided by the IRS. As a small business owner, you might be eligible for this credit if your company's tax deductions exceed your taxable income in a given year.
The IRS lets you carry forward the loss to set off future profits. This allows you to reduce your current-year tax payments to a time when your business makes more money. The idea is that your business pays taxes when it's making money — and is alleviated of this burden when it isn't making money. NOL is thus a valuable asset.
For accounting purposes, the NOL deduction you claim is considered a deferred tax asset. The losses will be classified in your accounting balance sheet as "noncurrent assets." It's important that you calculate NOL accurately because it can provide future tax relief for your business.
For example, let's say you have an NOL of -$5,000 in the tax year 2020. In 2021, you manage to turn a profit of +$20,000. You'll have to pay taxes on that profit, calculated as a percentage of $20,000. If the tax rate is 5%, for instance, you would owe $1,000 in taxes. However, you still have your $5,000 NOL, carried forward from 2020, to consider. This reduces your taxable income from $20,000 to $15,000. Apply that 5% tax rate to $15,000 and now you only owe $750.
Alternatively, you might be eligible to carry back the loss to receive a tax refund. This likely won't apply to you as a new business owner since you won't have an extensive tax record. The legal restrictions surrounding carrybacks are also stricter, making this an unlikely option for most taxpayers. We go into further detail on how to carry forward versus carry back NOL below.
How Do You Calculate Net Operating Loss?
On a business expense sheet, the net operating loss is calculated by subtracting your company's total itemized deductions from its adjusted gross income. If you end up with a negative number, you have net operating losses. Read on for a step-by-step guide to calculating NOL.
Follow the IRS Rules of Eligibility and Deduction
The IRS defines which types of deductions may contribute to your NOL. These include expenses related to business, trade, rent, moving, and money lost due to theft or casualty.
Excluded items you can't count toward your NOL include nonbusiness deductions for personal exemptions, deductions for domestic production activities, and net capital losses (if your capital losses exceeded your capital gains). This list is not exhaustive.
The IRS provides a worksheet that clarifies what is and isn't included in NOL. Look at IRS Publication 536 for a detailed update.
Determine Stakeholders' Equity
An NOL deduction is applicable only to some types of business entities (specifically, pass-through entities like sole proprietorships).
A partnership or S corporation isn't permitted to claim NOL. However, an individual partner or owner can claim their share of business losses on an individual tax return. This information is input into line 41 of Form 1040 (your individual income tax return).
If this scenario applies to you, the next step is to tally up your eligible deductions and determine stakeholders' equity. This simply refers to how much each stakeholder owns in the company. For example, if your company is an equally divided partnership with one other person, you each own a 50% stake in the company.
Calculate the NOL
Now, you can calculate the actual NOL amount. The formula itself is pretty simple. Here it is:
|- Eligible Deductions|
|Net Operating Loss|
Let's say you have a taxable income of $20,000 and your eligible deductions total $30,000. Here's your formula in action:
Determine Whether the Loss Is Carryback or Carryforward
Finally, you have to determine whether the loss you've calculated is carryback or carryforward. Here's the difference:
- NOL Carryback: If eligible, you can carry back an NOL up to two years before it was incurred. In this case, the NOL is applied against your taxable income to potentially give you a tax refund.
- NOL Carryforward: If eligible, you can carry forward your NOL and apply it to future tax years. In this case, the NOL is subtracted from your taxable income to reduce your overall tax bill in those future years (when you're theoretically going to be earning more since your business will be better established).
There are eligibility requirements as to whether you can carry back or carry forward your NOL. Changes to United States tax law made in 2018 mean that it's now almost impossible to carry back NOL, while restrictions on carrying forward NOL have been eased. Read on for the details.
How Do You Carry Back a Net Operating Loss?
For most taxpayers, NOL arising in tax years ending after 2017 can only be carried forward. This is due to a change in U.S. legislation, specifically the implementation of the Tax Cuts and Jobs Act (TCJA) in 2018.
Before the TCJA tax reform, businesses could carry back NOL for two years to get an immediate refund on taxes they had paid previously. For tax years starting Jan. 1, 2018, however, the TCJA eliminated the two-year carryback option. Instead, the revised legislation allows for an indefinite carryforward period, no longer capped at 20 years.
Note that there are exceptions for some types of farming losses.
How Do You Carry Forward a Net Operating Loss?
Prior to 2018, the IRS allowed businesses to carry forward NOL 20 years to net against future profits. This also changed due to the TCJA.
For tax years starting from Jan. 1, 2018, you're permitted to carry forward an eligible NOL indefinitely; the 20-year limit no longer applies. Note that carryforwards are limited to 80% of the next year's net income.
Again, there are exceptions for some types of farming losses.
A Note on Net Operating Losses and the CARES Act
Tax legislation changes, like the implementation of the TCJA, can directly impact you as a small business owner. On this note, there is another piece of legislation worth mentioning in relation to NOL: the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
The CARES Act of 2020 is designed to help businesses impacted by the COVID-19 pandemic. One section (internal revenue code section 2303) applies to NOL. The CARES Act removes the previously implemented restriction on carryback of losses. Now, taxpayers can waive the NOL carryback period for 2018, 2019, and 2020. The legislation removes the NOL carryback restriction in tax years starting after Dec. 31, 2017, and prior to Jan. 1, 2021, to each of the five taxable years before the year in which the NOL was incurred.
The details of this legislation are complex, and you should consult a tax professional to see whether carryback or carryforward is an option for you.
Maintain Accurate Financial Accounting Records Using Skynova
Net operating loss can be beneficial if you're just getting your small business off the ground and are not yet turning a profit. If eligible for this tax credit, you can minimize your immediate business tax burden.
The first step to determining NOL eligibility is keeping an accurate record of expenses and possible tax deductions. Skynova's accounting software can help you organize and track your financial paperwork, making it easier to determine whether an NOL will allow you to minimize your tax liability.
Notice to the Reader
The content within this article provides general information and may not apply to your specific situation. Always consult a professional accountant or another tax professional to ensure you're meeting accounting standards and tax obligations.