What You Should Know About Net Operating Loss Carryback Rules

By Stephen Fishman, J.D., University of Southern California Law School
Your business can lose money in a tax year for many reasons, including a bad economy or theft or casualty losses. When this occurs, the Internal Revenue Service allows you to use your losses against your income in future or past years for federal tax purposes.
If you’re a sole proprietor, it’s likely that your greatest fear is that your business will lose money. Unfortunately, this is an all too common occurrence. Your business can lose money in a tax year for many reasons, including a bad economy or theft or casualty losses. However, the dark cloud of business losses has a silver lining: The Internal Revenue Service (IRS) allows you to deduct your losses against your income in future or past years for federal tax purposes. This can result in a tax refund from the IRS of all or part of the taxes you paid in prior years. You might even be able to deduct your losses from your state taxes, but the rules for this vary from state to state.

Subtract Your Loss From Other Income

Your sole proprietor business has a loss for the year if all your deductible expenses listed in your Schedule C exceed your business income. The first thing to do is deduct this loss from any other income you may have. This includes your spouse’s income as well if you file jointly.

For example, if you had $20,000 in W-2 income from an employer, $2,000 in passive interest income, and $18,000 in business losses, you would pay tax on only $4,000 of income, or $22,000 minus $18,000.

You Can Apply Your Loss to Prior Tax Years

If your losses exceed your income from all sources for the year, you have a “net operating loss” (NOL for short). You are allowed to apply an NOL to past tax years. This is called carrying a loss back. The carryback period is usually two years, however a three-year carryback period applies if your net operating loss was the result of theft or a casualty.

Typically, you first use your loss against the tax return you filed two years ago. If you still have part of your NOL left, you apply it to your previous year's return. If there's still any loss remaining, you must carry it forward and apply it to your future year's return.

For example, if you have $50,000 in losses in the current tax year, and your taxable income was $30,000 two years ago and $15,000 last year, you'd get a refund for taxes paid in both those years and you could deduct $5,000 from your taxable income in the next year.

There are two ways to claim a refund for prior years’ taxes: You can file IRS Form 1040-X, Amended U.S. Individual Income Tax Return, within three years, or you can seek a quicker refund by filing IRS Form 1045, Application for Tentative Refund. If you file Form 1045, the IRS is required to send your refund within 90 days. However, you must file Form 1045 within one year after the end of the year in which the NOL arose.

You Can Carry Your Loss Forward

Instead of carrying a NOL back, you always have the option of waiving your carryback period and carrying your NOL forward—that is, applying it to future years’ tax returns. You can carry forward an NOL for up to 20 years.

You should carry a NOL forward if you paid no taxes in the prior two years. You may also elect to carry your NOL forward if you expect your income to greatly increase in future years, placing you in a higher tax bracket. The higher your tax rate, the more an NOL will save you in taxes. However, after you commit to this decision, you can't change your mind if your business doesn't do as well as you expect.

Calculating an NOL

Calculating a net operating loss can be complicated, and you may need the help of a tax attorney. It not as simple as deducting your losses from your annual income. Instead, you calculate your adjusted gross income for the year (which should be a negative number due to your losses) and then add back to it certain nonbusiness deductions to determine your NOL. These include the standard deduction or itemized deductions, deduction for the personal exemption, nonbusiness capital losses, IRA contributions, and charitable contributions. The resulting number is your net operating loss from business. You can use Schedule A of IRS Form 1045, Application for Tentative Refund, to calculate your NOL.

A Tax Lawyer Can Help

The law surrounding net operating losses is complicated. Plus, the facts of each case are unique. This article provides a brief, general introduction to the topic. For more detailed, specific information, please contact a tax lawyer.

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