Net operating loss carryforward: How it works and why it matters

If your business experiences losses in one year, you might be able to use those losses to offset taxable income in later years. The net operating loss (NOL) carryforward allows businesses to reduce tax liability by applying losses to taxable income in subsequent years. Here’s how the NOL carryforward works, the rules that govern it, and how it can help your business with tax planning.

What is a net operating loss (NOL)?

A net operating loss occurs when your business’s deductible expenses exceed its gross income for the year, resulting in negative taxable income. Both businesses and individual taxpayers can use NOLs to offset taxable income in future years. Under the Tax Cuts and Jobs Act (TCJA), NOL carryforwards are indefinite but limited to 80% of taxable income.

When does an NOL occur?

Businesses typically face NOLs during startup phases or in industries with fluctuating profits, such as retail or construction. These businesses may experience high initial investments and operating costs before achieving profitability.

Why NOL carryforwards matter

NOL carryforwards help your business offset taxable income in future profitable years, which can reduce your overall tax liability. By carrying forward losses, you can smooth out tax burdens and spread tax relief over several years. Here’s why this provision is important:

• Tax relief and strategic planning: NOL carryforwards allow your business to reduce taxable income in profitable years, smoothing out fluctuations in tax obligations. This is especially helpful if you’re running a seasonal or startup business.
• Improved cash flow: You can free up cash for reinvestment into operations or growth by reducing taxable income in future years

NOL carryforward rules and legislation

The rules surrounding NOL carryforwards have evolved over the years, especially after the TCJA went into effect.

Federal NOL carryforward provisions

• Indefinite carryforward period: You can apply NOL carryforwards indefinitely under the current rules, but businesses can only offset 80% of their taxable income in any given year
• Eighty percent limitation: For tax years beginning after 2020, the NOL deduction is limited to 80% of the taxable income for that year. This means your business must still pay taxes on 20% of its income, even if you have more than enough NOL carryforward to offset it.

Key NOL carryforward details

The table below lists different tax situations, including changes in the tax law. It includes how long you can carry forward the NOL based on tax law and details the percentage or limits on the deduction available each year. It also highlights the primary laws governing the NOL carryforward:

Deeper dive into NOL rules and legislation

To fully understand how NOL carryforwards work, it's important to explore the historical context, the impact of the TCJA on tax law, and how state-specific rules can affect businesses. Here’s how these rules have evolved and what you need to know to maximize your business tax benefits:

Historical context of NOL rules

Prior to 2017, you could carry back NOLs for up to two years. This carryback period allowed businesses to apply current-year losses against prior-year income and claim refunds for the taxes already paid. This provided immediate financial relief to businesses facing losses, especially those with cyclical revenue.

The Tax Cuts and Jobs Act of 2017 significantly changed the NOL rules because it:

• Eliminated the NOL carryback provision for most businesses (except for farming losses and certain insurance companies)
• Allowed for indefinite carryforwards, with more flexibility to apply their losses over time
• Introduced the 80% taxable income limitation, meaning you can only use NOLs to offset 80% of taxable income in any given year

These changes were designed to simplify the tax code and generate revenue, but they reduced the immediate tax benefits businesses could previously access.

State-specific NOL rules

While the federal tax system provides a general framework for NOL carryforwards, state-specific rules can significantly impact businesses with multistate operations. High-tax states such as California and New York often have their own rules for NOL carryforwards that differ from the federal guidelines.

For example, California limits its NOL carryforwards to 20 years, while the federal system allows for indefinite carryforwards. Some states may also impose a deductibility limit for NOLs, meaning you may not be able to apply your business’s full NOL in a given year, depending on state rules.

If your business operates in multiple states, you need to be aware of these state-specific differences since they could affect how you apply NOLs and the timing of tax relief. In some cases, you may need to file separate returns for state and federal taxes, making NOL tracking more complex.

International practices on NOL carryforwards

While NOL carryforwards are a common feature of tax systems worldwide, countries have different approaches to applying them. In many OECD countries, businesses are allowed to carry forward NOLs indefinitely, similar to the U.S. system under the TCJA. However, some countries impose restrictions on the amount of NOL that can be used in any given year or have a limited carryforward period.

These international differences highlight the importance of understanding the local tax laws when operating across borders. For multinational corporations, NOL management is a key part of global tax planning in order to optimize tax benefits in each jurisdiction.

For example:

• In Germany, businesses can carry NOLs forward for up to one year, but the carryforward amount is subject to taxable income limitations
• In the United Kingdom, the carryforward period is generally unlimited, but NOLs can only be applied to future profits that arise from the same business activity

How to calculate NOL

To calculate your NOL, start with your taxable income before applying the NOL deduction. Here’s how:

1. Begin by calculating your business's gross income and net income to establish your baseline for NOL determination
2. Subtract allowable business expenses, such as salaries, office rent, utilities, or depreciation
3. Add back certain non-business deductions, such as capital losses exceeding capital gains, personal exemptions, and qualified business tax deductions

You can use these losses to offset taxable income in future years. However, before applying your NOL, remember that you can’t use it to offset investment or passive income.

Net operating loss carryforward example

If your business has a $500,000 NOL and earns $400,000 in taxable income, you can use $320,000 of your NOL carryforward (80% of $400,000) to reduce your taxable income.

Carryforward vs. carryback: Which should you choose?

Consider these factors:

• Carryforward: Apply the NOL to future taxable income. This option works well if you expect higher profits in the coming years or want to spread the tax relief over multiple years.
• Carryback: Apply the NOL to previous years and receive a refund for taxes paid. Keep in mind, however, that carrybacks are limited to farming losses and have been largely eliminated for most businesses under the TCJA.

Tax planning strategies

NOL carryforwards are a key component of long-term tax planning. Take proactive steps to maximize your tax relief and minimize tax liability over multiple years. Here are some actionable strategies to help businesses optimize their NOL carryforward process in compliance with the Internal Revenue Code (IRC):

1. Track NOLs regularly

Track NOLs each year, documenting how much of the NOL carryforward has been used and how much remains. This way, you won’t lose track of potential tax savings. Keep a worksheet with the carryforward period, the amount applied to taxable income, and carrybacks or NOL carryovers from past years.

2. Work with a tax professional

Consult with a tax advisor or accountant to ensure you apply your NOL carryforwards correctly, especially if your business operates across multiple taxable years or jurisdictions. A professional can help you avoid errors and navigate regulations, including state-specific rules and changes in federal tax law.

3. Leverage tax software tools

Many businesses use tax software platforms to streamline their NOL calculation process and implement finance automation to reduce manual errors. These help track NOL carryforwards, automate tax filings, and integrate with accounting systems, reducing the chances of errors.

4. Strategically apply carryforwards

If you expect higher profits in future years, it might be worth it to apply a portion of your NOL carryforwards strategically, reducing taxable income in profitable years. Be mindful of the 80% limitation on NOL deductions post-2020, though, which may require you to spread the carryforwards over multiple years.

5. Reevaluate your strategy annually

Given that NOL carryforwards can last indefinitely, revisit your tax strategy every year. Evaluate whether it’s better to apply NOLs immediately or defer them to future years, depending on expected changes in profitability, tax law changes, and the future income of your business.

Filing and compliance: Forms, deadlines, and best practices

To claim your net operating loss carryforward, file the appropriate IRS income tax forms:

• Form 1040 for sole proprietors; Form 1120 for corporations
• Use IRS Publication 536 to track your NOL carryforward and comply with the 80% limitation

Be sure to keep detailed records of all NOL carryforwards to avoid mistakes when filing your tax return. This includes proper documentation for all business expenses and other deductible costs that contribute to NOL calculations. Maintain a worksheet tracking losses, carryforward amounts, and the years in which they apply.

Optimize your tax strategy with smart NOL planning

A well-planned NOL strategy helps you manage taxes, improve cash flow, and keep your business financially stable. By applying NOLs at the right time, you can reduce taxable income in profitable years and make sure no losses go unused. This also lets you align tax savings with business growth so you can reinvest in expansion, hiring, or paying down debt.

Using NOLs strategically gives you better control over tax fluctuations. Instead of dealing with unpredictable tax bills, you can spread out net operating loss deductions over multiple years. This is especially useful if your business has irregular income due to market shifts. A smart NOL strategy ensures you make informed tax decisions and strengthen your financial position.