You may not expect it to happen, and you certainly don't want it to happen, but sometimes your business costs and expenses are more than your taxable income. In other words, you have a loss for the year. The loss sometimes qualifies as a net operating loss (NOL). You can take a deduction for the loss on your federal income tax return.

Like many things in the tax code, 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, known together as "carryover" rules, provide the answer.

NOL Basics

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. However, 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 or limited liability company (LLCs)? How about 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.

Carryovers

NOLs are designed to help you offset income in past years or 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.

When you have a NOL at the end of the year, you generally have to carryback the whole NOL to the two tax years before the year. This is called the "carryback period." If there's any leftover NOL, you carryforward the balance for up to 20 years after the NOL year. This is called 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. There are also slightly different rules for non-corporate and corporate taxpayers.

Carryback for Non-Corporate Taxpayers

Carryback NOLs involve a multi-step, complicated calculation. You have to adjust and refigure a number of things, such as the taxes you owed and your taxable income in the carryback year. You also have to take into account 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 Form 1040 for that year
  • Recalculate certain income or deduction items for the carryback year. This includes the special allowance for passive activities, taxable Social Security benefits, IRA deductions and the deduction for student loan interest. This recalculation 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. This includes itemized deductions for medical expenses and casualty losses. Also, any miscellaneous itemized deductions that were subject to the 2% rule. This recalculation 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.

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