In the first years of opperation it is not uncommon that business costs and expenses are more than taxable income. In other words, you have a loss for the year. Sometimes, the loss qualifies as a net operating loss (NOL), and you can take a deduction for the loss on your federal income tax return in other years.
However taking the NOL tax deduction isn’t a simple matter. Once you’ve determined the amount of your NOL, you need to figure out when and how to take the deduction. Carryback and carryforward rules, are known together as “carryover” rules. These rules are outlined in IRS Publication 536.
You may have a NOL if you have a negative number on:
Line 41, Form 1040, which, for non-corporate taxpayers like individuals and sole proprietorships, shows your taxable income after you’ve taken your itemized or standard deduction. Line 28, Form 1120, which shows a corporation’s taxable income before it deducts a NOL or its “special deductions”.
NOLs are usually connected to running a business, but individual taxpayers with casualty and theft losses or business expenses can have a NOL. The NOL rules for individuals are the same as those for non-corporate taxpayers like sole proprietorships. Corporations, except S-Corporations, have slightly different NOL rules.
Are you in a partnership, limited liability company (LLCs), or a shareholder in a S-Corporation? Then the NOL rules generally don’t apply to you. Rather, you’ll claim businesses losses, subject to the passive activity rules, on your individual tax return.
NOLs are designed to help you offset income you had in past years or may have in the future. The idea is to give you the full “benefit” of your loss by letting you reduce your taxable income and lower your tax bill in years where you didn’t suffer a loss.
Generally, when you have a NOL at the end of the year (this is called the “NOL year”), then you have to carryback the whole NOL to the two tax years before the NOL year. This is called the “carryback period.” Then, if there’s any leftover NOL after the carry back period, you carryforward the balance for up to 20 years after the NOL year (the “carryforward period”). You can’t deduct any part of the NOL after the carryforward period.
You can waive the two-year carryback period and use the NOL for the carryforward period only. This may be advantageous if your taxable income in the past two years was low or if you expect to have a lot of taxable income after the NOL year. To waive the carryback period, you need to attach a statement to your original tax return for the NOL year specifying that you’re waiving the carryback period under Internal Revenue Code § 172(b)(3).
The carryback and carryforward periods are the same for non-corporate and corporate taxpayers, as is the rule for waiving the carryback period.
Taking the Deduction
There are different rules for claiming a carryforward or carryback NOL, and there are slightly different rules for non-corporate and corporate taxpayers.
Carryback for Non-Corporate Taxpayers
Carryback NOLs involve a multi-step, complicated calculation in which you have to adjust and refigure a number of things, such as the taxes you owed and your taxable income in the carryback year, and many of the deductions you took in that year. Using Form 1045, the process generally goes like this:
Deduct the NOL carryback amount to the adjusted gross income (AGI) you reported in the carryback year. AGI for the carryback year is the amount you entered on line 38 of your line 38, Form 1040 for that year
Recalculate certain income or deduction items for the carryback year, such as the special allowance for passive activities, taxable Social Security benefits, IRA deductions, and the deduction for student loan interest. This will give you a “revised AGI”
Using your revised AGI, recalculate certain deductions in the carryback year that were based on or limited by your AGI, such as itemized deductions for medical expenses and casualty losses, as well as any miscellaneous itemized deductions that were subject to the 2% rule. This will give you the “revised taxable income” for the carryover year.
Using the “revised taxable income,” recalculate your new tax liability for the carryback year
The IRS has detailed instructions and worksheets to help you with the calculation, namely the previously mentioned Form 1045 and the related schedules.
Carryforward for Non-Corporate Taxpayers
This is much less complicated. You simply list the NOL deduction as a negative figure on line 21, Form 1040. Also, you have to attach a statement to your return that shows how you calculated the NOL.
Carryovers for Corporate Taxpayers
Like non-corporate taxpayers, corporations have to modify and refigure taxable income for the carryover year. If the NOL available for a carryback or carryforward year is more than the corporation’s taxable income for that year, the corporation has to modify its taxable income to figure how much of the NOL to use in that year. Any leftover amount then carries over to the next tax year. The carryover amount is its modified taxable income for the carryover year minus the available NOL.
“Modified taxable income” is calculated the same way as taxable income: Gross income minus deductions. There are two exceptions for modified taxable income, though:
Only NOLs from years before the NOL year whose carryover is being figured can be deducted. So, if a corporation is figuring a NOL carryback for 2007, it can deduct only NOLs from years 2006 and before.
To report NOLs, corporations use:
Form 1139 for carryback NOLs
Form 1120, Schedule K for carryforward NOLs
Questions for Your Attorney
If I choose to waive the two-year carryback period, can I change the election later so that I can carryback a NOL?
I claimed a carryback NOL for 2007 and it created a tax refund for that year, which I received from the IRS in 2008. Do I have to report the refund as income on my 2008 return?
I’m thinking of buying a small business, and according to its books, it has an unused NOL from 2007. If I buy the business, do I get the NOL?