Net Operating Loss (NOL): Definition and Carryforward Rules

What Is 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 Internal Revenue Service (IRS) tax provision called a loss carryforward.

NOL tax laws have undergone significant changes in recent years. Net operating losses in 2021 or later may not be carried back, and NOL carryforwards are limited to 80% of the taxable income in any one tax period.

How a Net Operating Loss (NOL) Works

A net operating loss is a tax attribute that can be carried forward to offset taxable income in future years to reduce a company’s future tax liability. The purpose behind this tax provision is to allow some form of tax relief when a company loses money in a tax period. The IRS recognizes that some companies’ business profits are cyclical in nature and not in line with a standard tax year.

NOL carryforwards are recorded as an asset on the company’s general ledger. They offer a benefit to the company in the form of future tax liability savings. A deferred tax asset is created for the NOL carryforward, which is offset against net income in future years. The deferred tax asset account is drawn down each year, not to exceed 80% of net income in any one of the subsequent years, until the balance is exhausted.

A farming business, for example, may have significant profits and a large tax payment in one year, then incur an NOL in the next, followed by another profitable year. To smooth the tax burden, the loss carryforward provision allows for the NOL in the second year to offset taxes due in the third year.

How to Calculate Net Operating Loss (NOL)

Net operating loss is calculated by subtracting allowable tax deductions from taxable income.

If the resulting figure is negative, there’s a net operating loss. When this happens, the business can carry some of its tax deductions forward to years when it has a profit.

Net Operating Loss (NOL) Tax Law Changes

Net operating loss has been subject to several tax law changes over the past few years.

Before the implementation of the Tax Cuts and Jobs Act (TCJA) in 2018, the IRS allowed businesses to carry net operating losses forward 20 years to net against future profits and backward two years for an immediate refund of previous taxes paid. Because the time value of money shows that tax savings in the present are more valuable than in the future, the carryback method was generally used first, followed by the carryforward method. After carrying losses forward for 20 years, any remaining losses expired and could no longer be used to reduce taxable income.

Tax Cuts and Jobs Act (TCJA)

In 2017, the Tax Cuts and Jobs Act (TCJA) made significant changes to the laws regarding net operating losses. The TCJA removed the two-year carryback provision for tax years beginning Jan. 1, 2018, or later, except for certain farming losses, but allowed for an indefinite carryforward period. However, the carryforwards are now limited to 80% of each subsequent year’s net income. If a business creates NOLs in more than one year, they are to be drawn down completely in the order that they were incurred before drawing down another NOL.

Coronavirus Aid, Relief, and Economic Security (CARES) Act

The Coronavirus Aid, Relief, and Economic Security (CARES) Act effectively suspended the changes made by the TCJA. The pandemic relief bill allowed NOLs arising in tax years beginning in 2018, 2019, and 2020 to be carried back for a period of five years and carried forward indefinitely. However, those special exceptions have now expired.

Net Operating Loss (NOL) Carryforward Example

Imagine a company that had an NOL of $5 million one year and a taxable income of $6 million the next. The carryover limit of 80% of $6 million is $4.8 million.

The full loss from the first year can be carried forward on the balance sheet to the second year as a deferred tax asset. The loss, limited to 80% of income in the second year, can then be used in the second year as an expense on the income statement. It lowers net income, and therefore the taxable income, for the second year to $1.2 million ($6 million - $4.8 million). A $200,000 deferred tax asset will remain on the balance sheet to be carried into the third year.

Net Operating Loss (NOL) Carryforward Limitations

A net operating loss is a valuable asset because it can lower a company’s future taxable income. For this reason, the IRS restricts using an acquired company simply for its NOL’s tax benefits.

Section 382 of the Internal Revenue Code states that if a company with an NOL has at least a 50% ownership change, the acquiring company may use only part of the NOL in each concurrent year. However, purchasing a business with a substantial NOL may mean a larger sum of money going to the acquired company’s shareholders than if the acquired company possessed a smaller NOL.

The Bottom Line

Posting a loss is never a good thing. However, there is at least one positive to take from it: It’s possible to use a loss to offset taxable income in future years in a process called loss carryforward.

There are some limitations, though. From the 2021 tax year, you can no longer carry back a loss from one year to a previous year. Moreover, carryforwards are now limited to 80% of each subsequent year’s net income.