If you're like most small business owners, you won't see a profit in your first year of operation. And as your business grows, you may face one or more years in which your business's expenses exceed its income. In other words, the business may have a loss, which may translate into a net operating loss deduction. How this loss can be used to offset other income depends upon how your business is structured.
The net operating loss (NOL) deduction is one of the rare exceptions to the general income tax rule that your taxable income is determined solely on the basis of your current year's events. An NOL deduction allows you to offset one year's losses against another year's income.
A net loss from the operation of a trade or business, casualty losses, and losses resulting from employee business expenses can generate a net operating loss. However, NOLs most often result from losses from a trade or business.
Complex rules govern partnership and corporate NOLs
The rules governing partnerships, S corporations and regular corporations are complex and their nuances are beyond the scope of this article. However, the following information is provided so that you have some familiarity with the principles that will affect your tax situation.
Partnerships and S corporations.
Generally, a partner's share of the partnership loss (including capital loss) is allowed only to the extent of the adjusted basis of his or her partnership interest at the end of the partnership's tax year in which the loss occurred (but before reduction by the current year's loss). This is not necessarily the same as the balance in the partner's capital account. Any excess is allowed as a deduction in later years to the extent that the partner's basis is increased above zero.
The rules for S corporation shareholders are similar, with one major exception: a shareholder of an S corporation only increases his or her basis in the shares by any loans made directly from the shareholder to the corporation. Indebtedness guaranteed by a shareholder does not increase basis. Thus, a shareholder's basis in his or her interest will be less, in most cases, than a partner's.
The partner's or shareholder's allowable loss may be deducted by the partner on his or her individual returns as a business loss, subject to the passive activity rules. Although the partnership itself may not carry the loss backward or forward to other years as a net operating loss, the partners' shares of the loss may result in NOL carrybacks or carryovers on their individual returns. For more information on how this would work, consult your tax adviser.
Regular (C) corporations.
If your business is organized as a C corporation, any NOL it suffers provides no tax benefit to the shareholders. Such a loss can only be used by the corporation itself: it may be offset against the income of its subsidiaries (if any) if a consolidated return is filed, carried back against past income, or carried forward to reduce future income.
A corporation can normally carry a net operating loss back two years and forward 20 years. If net operating losses are anticipated by a corporation, it may be beneficial to elect S corporation status and pass the losses on to the shareholders.
Sole proprietorship can use NOLs to reduce taxes in other years
If you have a net operating loss from your sole proprietorship, you'll normally be able to deduct the loss from your total income from other business ventures or from any salary, wages, or other earnings.
If the business loss exceeds your total income for the year, any unused portion of the loss can be used to offset income and reduce taxes in another year.
The remainder of this discussion is intended to give you a basic understanding of how NOLs work for sole proprietors.
Although you can find basic information about net operating losses in this article and in the IRS Publication 536, Net Operating Losses., calculating an NOL is very tricky. We strongly suggest that, if you have one, you consult a professional to help ensure you do it correctly.
Determining NOL amount
If your business expenses are more than your business income, you may have a net operating loss (NOL) for the year. However, simply having a negative amount on the taxable income line on your income tax return is not a guarantee that you actually have a net operating loss. There there are many adjustments that must be made to your tax calculations before you can know for sure whether you have an NOL.
Computing the amount of an NOL can become complicated because the NOL computation follows different rules than the regular tax computation. The following items are ordinarily deductible on your tax return. However, they cannot be deducted for purposes of determining whether you actually have an NOL:
- personal exemptions for yourself, spouse, and dependents;
- net capital losses, which are subject to different carryover rules;
- nonbusiness losses;
- NOL deductions from other years; and
- nonbusiness deductions such as:
- medical deductions,
- charitable deductions,
- real estate tax on your residence,
- deductible IRA contributions, and
- the standard deduction (if you don't itemize.)
Calculate NOL using Form 1045
You should use Schedule A of Form 1045, Application for Tentative Refund, to determine whether your loss is a net operating loss. Although the form is used to apply for a refund based on the carryback of the NOL, you should use it to compute the NOL regardless of how you chose to carryover it over. If you don't rely on a tax professional to prepare your returns, the instructions to Form 1045 (and/or your tax preparation program) will help you work through the computation.
Understanding NOL carryover rules
Once you've determined the amount of your net operating loss (NOL) in your sole proprietorship business, you need to decide whether to carry the loss backward (and claim a retroactive refund), or forward.
Carryover period. NOLs are usually carried back to offset prior years' income before they are carried forward against future years. Net operating losses may generally be carried back for two years (or for three years, in the case of a casualty loss) before the year of the loss, which is called the NOL year.
If the loss it carried back, it is used to offset the taxable income of previous years, with the earliest year offset first. If the loss is not fully used up in the carry back years, any unused portion of the loss may be carried forward for up to 20 years after the NOL year. Any NOL that is not used up in the carryover period is lost.
Election to forego carryback. You can elect to forgo the carryback period. If you forego the carryback period, you can still only carryover the loss for 20 years into the future.
Because the IRS assumes that most people will want the speedy refund a carryback can provide, you must attach a statement to your tax return for the NOL year, or to an amended return for that year filed within six months of its due date excluding extensions. The statement must assert that you are electing to forgo the carryback period under Section 172(b)(3) of the Internal Revenue Code.
Carrying back a net operating loss to a prior tax year can result in a quick tax refund. As a result, it is usually be unwise to pass up the carryback period.
One exception to this guideline is when you're quite sure that your business will be in a higher tax bracket in the future.
Understanding how the carryback works
When you carry back an NOL, you must completely redo your income taxes for the carryback year. (However, you do not make any changes to your self-employment tax liability!) This means that you must:
- Recompute your adjusted gross income (AGI)
- Recompute any items that were limited by your AGI amount, such as the special allowance for passive activities, taxable Social Security benefits, IRA deductions, and excludable savings bond interest.
- Recompute your taxable income to reflect any changes in your itemized deductions that were limited by your AGI. For example, medical expenses, casualty losses, miscellaneous itemized deductions, and the phaseout of personal exemptions for higher-income taxpayers.
- Recompute your AMT, if you had any for that year.
If you don't use up your entire NOL in the first carryback year, you may have a carryover, and you'll need to use Schedule B of Form 1045 to compute the amount.
If you carry forward an NOL, things are a little simpler. Simply list your NOL amount as a negative amount on the "other income" line of Form 1040 (Line 21), and attach a statement showing how you computed the NOL.
Claiming an NOL for prior years
You have two options for "carrying a loss back." First, you may file a Form 1045, Application for Tentative Refund within one year of the end of the NOL year. Or, you can file an amended tax return on Form 1040X for the year to which you are carrying the loss. Form 1040X must be filed no later than three years after the due date of the return for the applicable tax year.
You have a net operating loss for 2011. You filed your tax return on April 17, 2012, you can file Form 1045 any time before December 31, 2012, one year after the close of the loss year. You have until April 15, 2015 to file an amended return on Form 1040X to carry back the NOL.