How to carry forward net operating losses

A net operating loss (NOL) happens when a business's deductible expenses exceed its taxable income for the year. Instead of losing that financial setback, the IRS allows businesses to use NOL carryforward.

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This means they can apply those losses to future tax years to lower their taxable income. NOL carryforward helps businesses offset profitable years, reducing the amount of tax owed.

What is a net operating loss (NOL)?

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When you spend more on operations, payroll, and other costs than you earn in revenue, you will report a net operating loss. These losses are common for startups or businesses in unpredictable industries. They can happen due to high initial investments, unexpected market shifts, or industry-specific challenges.

How to calculate NOL

By calculating your NOLs, you can figure out how much of your losses you can use to reduce your future taxable income.  

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Start with your taxable income before applying deductions. You can find this on your federal tax return. Use Form 1040 if you are a sole proprietor or Form 1120 if you are a corporation. Then, subtract all eligible business expenses, such as rent, payroll, utilities, and depreciation. If your total expenses exceed your taxable income, you may have an NOL.

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However, not all deductions will count toward your NOL. You must add back certain nonbusiness deductions, including:

• The qualified business income (QBI) deduction (up to 20% for pass-through businesses)
• The standard deduction or itemized deductions
• Capital losses that exceed capital gains
• Non-business deductions, such as personal exemptions

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Once you adjust for non-deductible items, the remaining negative amount is your NOL. You can use these losses to offset taxable income in future years. However, before applying your NOL, you should remember that you cannot use it to offset investment or passive income.

What is a carryforward?

A carryforward is a tax policy that lets you apply unused deductions, tax credits, or losses to future taxable years. This helps lower your taxable income and reduce your tax bill when your business becomes profitable. One of the most common types is the net operating loss (NOL) carryforward, which lets you use business losses from one year to offset future taxable income.

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The IRS permits businesses to carry forward NOLs indefinitely, but you can only use them to offset up to 80% of taxable income per year under the 2017 Tax Cuts and Jobs Act. This rule ensures that businesses still pay some taxes, even when applying past losses.

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Using these carryforwards correctly allows you to manage your cash flow, smooth out tax obligations, and reinvest savings into growth.

Carryforward vs. carryback: Which option should you choose

When your business has a net operating loss (NOL), you can choose to carry it forward or carry it back. Both options help lower your tax burden.

Carryforward to reduce future tax bills

A carryforward allows you to apply your NOL to future years. This lowers your taxable income when your business becomes profitable. This option works best if:

• You expect higher profits in the subsequent years.
• You want to spread out income tax savings instead of getting an immediate refund.
• Your business operates in an industry with fluctuating earnings.

Carryback to get an immediate tax refund

A carryback lets you apply NOLs to past tax years and claim a refund for taxes you already paid. Before 2017, businesses could carry back NOLs for up to two years. However, the Tax Cuts and Jobs Act (2017) removed this option for most businesses, except for industries like farming and insurance. A net operating loss carryback provision is useful when:

• You need quick cash flow from a tax refund.
• Your business was profitable in prior years but recently faced losses.
• You prefer recovering past taxes instead of waiting for future savings.

Advantages of NOL carryforward for businesses

NOL carryforward strategically helps businesses recover from financial downturns. It is quite useful for startups, seasonal businesses, and industries with fluctuating earnings, such as retail, manufacturing, technology, and real estate.

Reducing tax burdens over time

Instead of paying full taxes in a profitable year, you can use NOLs to offset taxable income, reducing what you owe. This creates long-term tax savings and frees up cash for reinvestment.

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As we discussed earlier, the IRS allows businesses to carry forward NOLs indefinitely, but they can only offset up to 80% of taxable income per year under current tax laws. This rule ensures businesses gradually recover losses while still paying some taxes.

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For example, if a business has a $500,000 NOL and earns $400,000 in taxable income, it can apply $320,000 (80%) of the $400,000 in taxable income as a loss, reducing taxable income to $80,000. The remaining $180,000 NOL carries forward to future years.

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This is especially beneficial for businesses in cyclical industries like retail, agriculture, and real estate, where profits vary from year to year.

Improving cash flow for your business

By applying your losses and reducing your taxable income, the NOL carryforward strategy makes sure you have more cash on hand. You can then use these funds for daily operations, investments, and growth.

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A 2023 survey found that 66% of small businesses struggled with cash flow last year. This is usually because their net income often doesn't align with their expenses—revenue can be unpredictable, while fixed costs like rent, payroll, and supplies remain constant. Using NOL carryover here can reduce financial stress and keep funds available when profits return.

Providing a safety net for volatile industries

Businesses in the hospitality, agriculture, energy, or manufacturing industries often deal with unpredictable demand and market shifts. This makes them more prone to losses and financial stability.

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NOL carryforward provides stability to such businesses. It gives you a financial cushion by letting you offset future profits with past losses. This reduces tax burdens when your business becomes profitable again.

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For example, in the oil and gas industry, energy companies often struggle with falling oil prices. By carrying forward NOLs, they lower their tax bills when prices rise, freeing up cash for operations and expansion.

Encouraging strategic long-term planning

When you know that past losses can offset future profits, you can forecast your tax liabilities more accurately. This allows for better budgeting, cash flow management, and financial decision-making.

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NOL carryforwards allows you to allocate your resources better. Instead of setting aside large reserves for potential tax payments, you can reinvest those funds into hiring new employees, expanding operations, upgrading technology, or purchasing equipment.  

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It also helps smooth out financial fluctuations, ensuring that profitable years aren't weighed down by heavy tax burdens. This stability allows for more strategic investments in research and development, product expansion, and marketing efforts, ensuring that businesses can sustain in the industry.  

How to apply NOL carryforwards?

You need to calculate and apply your NOL carryforwards each year until the entire loss is used or no longer provides a tax benefit.

Documentation for NOL carryforward

The Internal Revenue Service requires detailed documentation to support your NOL carryforward deduction. You need to provide enough proof that your losses were legitimate and properly calculated. Without the right documentation, your NOL claim could be denied or can even trigger an IRS audit.

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To apply an NOL carryforward, you need:

• Tax returns from the loss year: Keep a copy of the original income tax return where the NOL was first reported. This serves as proof of the loss and ensures accurate reporting when applying the carryforward.
• Financial statements: Maintain income statements, balance sheets, and cash flow statements for the loss year. These documents help verify business losses and track how they were incurred.
• IRS Form 1045 or Form 1040/1120: Use Form 1045 if you need a quick refund due to an NOL carryback. If you only carry forward losses, report them on Form 1040 (for sole proprietors) or Form 1120 (for corporations) when filing taxes.
• NOL worksheets (IRS Publication 536): These worksheets help track how much of the NOL has been used and how much remains. Keeping this updated ensures you don’t miscalculate deductions in future years.
• General ledger and bookkeeping records: Ensure your bookkeeping records align with the reported NOL. This includes transaction records, receipts, and invoices supporting your claimed deductions.
• Payroll and employment tax records: If employee wages contributed to the loss, maintain detailed payroll records. This includes W-2s, payroll tax filings, and benefits expenses.
• Depreciation and amortization schedules: If your loss includes depreciation or amortization expenses, keep records showing how these deductions were calculated.

Step-by-step NOL application process

Applying an NOL carryforward requires accurate calculations. If you are a small business with simple tax situations, you can handle the process yourself using IRS guidelines and tax software. However, if you have multiple carryforwards, large NOL deductions, or business mergers, you may need a tax professional to apply for NOL carryforwards.

Calculate and track your NOL

You would first need to determine your net operating loss by subtracting your allowable business deductions from your taxable income. You can read more about the NOL calculation process in the above section, where we've discussed this in detail.

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If you have NOLs from previous years, you will need to check how many of them remain. The IRS allows you to offset up to 80% of taxable income per year, so tracking your balance helps ensure you apply the right amount each year.

Report your NOL on your tax return

When filing taxes, you must report the NOL carryforward correctly. Sole proprietors, partnerships, and S corporations should use Form 1040, Schedule 1 under "Other Income", and attach IRS Publication 536 worksheets to track usage. Corporations should report NOL carry forwards on Form 1120 under "Deductions."

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Each year, you need to calculate and apply your NOL until it is fully used. However, if other deductions and credits already reduce your taxable income enough that the NOL wouldn’t provide additional tax savings, you should not apply it that year.

Maintain proper documentation

The IRS requires you to keep tax returns, financial statements, and supporting records for at least three years after fully using the NOL. Proper documentation protects you in case of an audit and ensures you don’t lose tax savings due to missing records.

Limitations and important considerations

To determine how much tax relief you can claim and when you can use it, you must first understand the key considerations for loss carryforwards.

Restrictions based on business type

The IRS sets different rules based on business structure, which affects how losses are used, who can claim them, and when they can be applied.

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C corporations: The carryforward period for your federal NOLs is indefinite, but they can only offset up to 80% of annual taxable income under current tax laws. If your business changes ownership by more than 50%, Section 382 of the Internal Revenue Code limits how much NOL you can use each year. The allowable deduction is capped at the company's fair market value at the time of the ownership change multiplied by the IRS long-term tax-exempt rate. This is put in place to prevent companies from acquiring businesses with large NOLs just to reduce taxable income.

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S corporations and partnerships: These pass-through entities don’t claim NOLs at the business level. Instead, losses pass through to individual owners, who can deduct them on personal tax returns based on their share of ownership. However, basis rules, at-risk rules, and passive activity loss limits may restrict how much you can claim each year.

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Sole proprietors and single-member LLCs: These businesses report NOLs on individual tax returns (Form 1040, Schedule 1). While they can carry forward losses, deductions may be limited by the taxpayer’s total income, filing status, and other deductions. If income is already low or reduced by the standard deduction and credits, applying an NOL may not provide additional tax savings. In some cases, higher earners may also face limitations due to Alternative Minimum Tax (AMT) rules.

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Nonprofits: Tax-exempt organizations usually can’t use NOL carryforwards. However, if your nonprofit has unrelated business taxable income (UBTI), you can apply losses to offset that income but not general operating expenses.

Expiration and Carryforward Limits

Before 2018, the carryforward period for NOLs was up to 20 years. The 2017 Tax Cuts and Jobs Act (TCJA) removed this time limit, allowing you to carry forward losses indefinitely. However, for losses after 2017, you can only use NOLs to offset up to 80% of taxable income per year. Before the TCJA, businesses could use 100% of NOLs to offset taxable income.

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If you have NOLs from before 2018, they may still expire after 20 years. However, they would still follow the old rules, meaning they can offset 100% of taxable income. Any unused portion after that is lost.

Managing NOLs with the right tools and resources

Using the right tools makes managing NOL carryforwards easier and more accurate. Automated tools help you stay organized, ensuring every deductible expense is recorded correctly. Over time, this improves cash flow management and allows you to strategically apply NOLs for maximum tax savings.

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Accounting and tax software like QuickBooks, Xero, and TurboTax Business simplify NOL management. They automate calculations, track carryforward balances, and sync with your financial records.

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For this, accurate expense tracking is also essential, and that's where Ramp can help. It connects directly to your accounting software, automatically tracking expenses from bills to card charges. It also ensures that all transactions are properly categorized.

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Accounting tools that automatically update based on tax law changes help you stay compliant, avoid penalties, and ensure accurate filings. They adjust calculations to reflect the latest IRS rules, reducing the risk of errors that could trigger audits or lead to lost tax savings.

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.

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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.