What is a net operating loss (NOL)?

A net operating loss (NOL) is like a raincheck…

When a store is out of something on sale, you can get a raincheck allowing you to get the discount in the future. Similarly, a net operating loss is a credit you can use down the line. If your business has a less-than-stellar tax year, you can apply the credit at a more profitable time.

A net operating loss (NOL) happens when your allowable tax deductions exceed your taxable income in a given year. Some years are less profitable than others. A net operating loss can smooth out the tax liabilities of good years using tax credits earned from not-so-good years.

Here’s how it works for different kinds of taxpayers:

You don’t have to be in business to have a net operating loss. If you experience losses to your home, vehicles, or personal property from casualty or theft due to a federally declared disaster, you may be able to claim an NOL if your deductible loss is more than your income for the tax year.

Sole proprietors and single-member LLCs are considered “pass-through entities” by the Internal Revenue Service — tax liability passes through to the individual business owner. Individual business owners use Schedule C to report their business’s profits and losses. When total business expenses are higher than total revenues, there is an NOL. This information is then carried over to the individual’s tax return to determine if there is a claimable NOL.

S-corporations and partnerships (LLCs with two or more members are taxed as partnerships unless they elect to be taxed as a corporation) are also pass-through entities. But because there can be multiple owners, the amount of the business income and loss that passes through depends on an individual’s percentage of ownership. Partners or shareholders can use their separate shares of the business’s income and deductions to determine whether they can claim an NOL on their individual tax returns.

C-corporations are taxed at the company level. Any NOL a corporation incurs does not pass through to shareholders. While the rules concerning an NOL carryforward are generally similar for C-corporations, corporate taxes are very complex. C corporations may want to seek the guidance of a tax professional to determine whether they should claim an NOL.

A net operating loss (NOL) carryforward allows you to deduct the losses that you incur in the current tax year from your next year's taxable income to lower your tax liability. You can carry an NOL forward to future years indefinitely, but the NOL carried forward cannot exceed 80 percent of a given year's taxable income.

If your NOL exceeds 80 percent of the next year's taxable income, you can continue to carry the remainder into future years, but each NOL must be deducted in the order that it occurred. For example, if you have an NOL in 2019, you can carry it forward to your 2020 taxes as a credit of up to 80 percent of your 2020 income. But if you end up having another NOL in 2021, you must deduct the remaining 2019 NOL before using the one from 2021.

The NOL carryforward rules changed with the Tax Cuts and Jobs Act (TCJA) of 2017. For tax years before 2018, NOLs could be carried forward with no income limits for up to 20 years, or carried back to previous years for up to two years. After the TCJA, only certain farming businesses, as well as property and casualty insurance companies, can still carry back.

If you still have NOLs from the 2017 tax year or earlier, you can continue to carry the NOL according to the old rules on your 2019 taxes. For NOLs that occurred from 2018 on, you can only carry forward up to 80 percent of your 2019 taxable income, but you can carry NOLs forward indefinitely (no 20-year limit).

To determine whether you have an NOL for 2019, you can only include deductions from:

• Trade or business
• Casualty and theft losses resulting from a federally declared disaster
• Rental property

You aren’t allowed to use a previous year’s NOL or the standard deduction to calculate NOL for 2019. There are other deductions that aren’t allowed, so it’s best to check the IRS website or consult with a tax professional to make sure you are considering the proper deductions.

You can calculate NOL using the Internal Revenue Service’s Publication 536 worksheet. Individuals subtract their standard or itemized deductions from their adjusted gross income (estates and trusts use their taxable income with some deductions added back in). From there, the worksheet considers things like capital gains and losses for the individual and business, nonbusiness income and deductions, and NOL deductions from past years. If the result is less than zero, it’s an NOL.

For example, say, Taxpayer Bob owns a small gift shop as a sole proprietor and works part-time as a bartender.

Bob is single and is filing his taxes using Schedule C and Form 1040 for 2019. He will also use the IRS net operating loss worksheet to figure his NOL.

Income Bartending Wages = $6,000 Interest from savings account = $200

Bob's Total Income = $6,200

Deductions Net loss from gift shop business (gross income of $40,000 minus expenses of $50,000) = -$10,000 Standard deduction = $12,000

__Bob's Total Deductions = $22,000 __

Bob's deductions are more than his income: $22,000 - $6,200 = $15,800

NOL

But not all deductions or income are allowed to figure in an NOL. In Bob's case, he is not able to claim the nonbusiness deductions (standard deduction of $12,000) or his nonbusiness income (savings account interest of $200).

Nonbusiness deductions (standard deduction $12,000) - nonbusiness income (interest from savings account $200) = $11,800

Bob subtracts the disallowed items from his total deductions ($22,000 - $11,800 = $10,200).

Bob's NOL for 2019 is his income of $6,200 minus his total adjusted deductions of $10,200.

__Bob's NOL for 2019 = $4,000 __

Bob can carry this loss of $4,000 forward to the 2020 tax year to lower his income tax liability. But he can only carry over an NOL that is 80 percent of his taxable income in 2020. This means that if Bob makes less than $5,000 ($4,000 is 80 percent of $5000), he would only be able to carry a portion of the NOL forward to 2020. He could then carry the remainder forward to 2021.

Businesses that have an NOL record them on their balance sheets as an asset because an NOL lowers the business's tax liability. If the NOL is more than 80 percent of the next year's income, the remainder can be carried into future years as an asset on a business's balance sheet.

Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals.