There are times when you lose money. Businesses big and small, and sometimes individuals, may have more costs and expenses than they have in income or profits. This may result a net operating loss (NOL for short). Losing money is never fun. But there is at least one silver lining in this dark cloud: You can deduct your NOL from the taxes you paid in prior years and get a refund, or you can apply it to future years to lower your tax bill. This will help you recover some—but usually not all--of your loss.
Figuring out how much you can deduct is complicated. Your potential tax savings, however, makes it worth your time to learn how NOLs work.
What's an NOL and Who Can Claim It?
Generally, NOLs occur when you have more tax deductions than taxable income. You can figure this out easily by completing your tax return. You may have an NOL if you have a negative number on the line for taxable income before you deduct your personal exemptions (line 41 on Form 1040).
NOLs usually happen in business. They can occur in businesses of all sizes, from small sole proprietorships to big corporations. However, it is possible for an individual who is not a business owner to have an NOL. This can occur when a person has large casualty and theft losses—for example, a taxpayer’s home burns down and he or she had no or inadequate fire insurance, resulting in a large deductible casualty loss that exceeds the taxpayer's income. In such cases, follow the rules for non-corporate taxpayers, such as sole proprietorships and independent contractors.
Businesses organized as partnerships, limited liability companies (LLCs), and S corporations, generally can't take deductions for NOLs. This is because the losses they incur are passed through to their owners who may deduct their share of the losses on their individual returns.
What Do You Do with Your NOL?
The idea behind NOLs is simple: If your business losses are more than your total income for the year, you can use the excess loss to lower your income and reduce your taxes in another year. The IRS carryback and carryforward rules govern how you do this.
First, you can carry a loss back--that is, apply it to prior year’s taxes you already paid and get a refund from the IRS. For example, if you have an NOL in 2016, you can use it to lower your taxes in 2014 or 2015. Instead of claiming a tax refund from prior years, you can carry a loss forward for up to 20 years. This means you deduct it from your future year’s taxes until you use it up.
How Much is Your NOL?
Use the information on your tax return and Form 1045, Application for Tentative Refund, to determine the size of your NOL. Be careful. The rules and formulas are complicated, and they're different for non-corporate and corporate taxpayers.
If you’re a non-corporate taxpayer (that is, a sole proprietor), when you calculate your NOL you must exclude a number of deductions you may have taken on your individual tax return. For example, when calculating your NOL, you can't include:
- personal exemptions for yourself, spouse, children, and other dependents
- net capital losses--the amount that your capital losses are more than your capital gains (capital gains and losses arise from the sale of capital assets, like stocks)
- NOL deductions from prior years
- certain non-business deductions, including a deduction for alimony paid by you; certain itemized deductions, including medical payments and charitable contributions; and the standard deduction, if you didn't itemize
The NOL calculation does include:
- itemized deductions for casualty and theft losses, state income tax on business profits, and any employee business expenses
- moving expenses, and
- the deduction of half of your self-employment tax.
Example: Let’s say you're the sole proprietor of a small business and you also have a part-time job. Your 2016 tax return looks like this:
Your income totals $5,500:
- Wages from part-time job = $3,500
- Interest income from personal savings account = $500
- Net long-term capital gain on the sale of gold held for investment = $1,500
Your deductions total $18,350:
- Net business losses = $7,500 (gross income $68,500 minus $76,000 in expenses)
- Net short-term capital loss on sale of stock = $1,500
- Standard deduction = $5,700 (you're single)
- Personal exemption = $3,650
Your deductions are more than your income, so you may have an NOL. To find out, go to Form 1045, Application for Tentative Refund and take out certain items:
- Non-business net short-term capital loss on sale of stock = $1,500
- Non-business deductions = $5,200 (standard deduction minus non-business interest income, or $5,700 - $500)
- Personal exemption = $3,650
- Total = $10,350
So, for 2016, you have an NOL of $2,500: Deductions minus Form 1045 removed items minus total income = NOL ($18,350 - $10,350 - $5,500 = $2,500).
If you carryback your NOL to obtain a tax refund from the IRS, you can file IRS Form 1045, Application for Tentative Refund. 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. Alternatively, you can file IRS Form 1040-X, Amended U.S. Individual Income Tax Return. You have three years to file this form.
Corporations generally figure and deduct an NOL the same way as non-corporate taxpayers. First check if you have an NOL. The key figure is on of line 28, Form 1120, U.S. Corporation Income Tax Return. If it's negative, there may be an NOL.
The main differences between corporate and non-corporate NOLs are that corporations:
- can't use the domestic production activities deduction to create or increase an NOL
- can use the deduction for dividends paid on certain preferred stock of public utilities, without limiting it to its taxable income for the year
- can take the deduction for dividends received, without regard to the aggregate limits that normally apply.
The last difference is the most important for many corporations. Normally, a corporation can deduct dividends received from other U.S. corporations, but the deduction is limited to a total of 70% or 80% of the corporation's taxable income. However, if the corporation has an NOL, the taxable income limitation doesn't apply.
Example: In 2016, Corporation A had $500,000 of gross income from business operations and $625,000 of allowable business expenses. It also received $150,000 in dividends from a U.S. corporation for which it can take an 80% deduction, which would normally be limited to 80% of its taxable income before the deduction.
The corporation calculates its NOL as follows:
- Gross income = $650,000 (business income + dividends ($500,000 + $150,00 = $650,000), minus
- $625,000 deduction for expenses, minus
- $120,000 deduction for dividends-received ($150,000 x 80% = $120,000).
For 2016 it has an NOL of $95,000 ($650,000 – $625,000 – $120,000 = $-95,000)
To report NOLs, corporations use:
- Form 1139, Corporate Application for Tentative Refund for carryback NOLs
- Form 1120, Schedule K for carryforward NOLs
Questions for Your Attorney
- What kinds of records do I need to keep to prove a net operating loss for my small business?
- My small business had net operating losses for the past two years. Is there a limit on how many NOLs I can use?
- I bought an existing small business in 2015, and at that time it was operating at a loss. Can I use those losses when calculating my 2016 net operating loss?