Carryback and Carryforward of Net Operating Losses

If you've experienced a loss in your business or investments, you may be able to take advantage of carryback provisions to offset your taxable income and potentially receive a tax refund. Here's what you need to know about maximizing your loss deduction through carryback provisions.

Carryback Basics

Carryback is a tax provision that allows individuals or businesses to use losses from a previous year to offset taxable income in the current year. This means that if you had a net operating loss in a previous year, you can apply that loss to reduce your taxable income in the current year, which may result in a lower tax liability or even a refund.

Loss Carryback vs. Loss Carryforward

There are two types of carryback provisions: loss carryback and loss carryforward. Loss carryback allows you to apply the losses from the previous year to reduce the taxable income of the current year. For example, if you had a net operating loss of $50,000 in 2020, you could carry that loss back to the previous year (2019) and apply it against your taxable income for that year. This could potentially result in a tax refund if your taxable income for 2019 is reduced to zero.

On the other hand, loss carryforward permits you to carry over unused losses to future tax years. If you had a net operating loss of $50,000 in 2020 and you can't use the full amount of the loss in the previous year, you can carry the remaining balance forward to future years. For example, you could use $3,000 of the loss in 2020 to offset your taxable income, and then carry forward the remaining $47,000 to future years. You can continue to carry forward the loss until it is fully used up or until a certain time limit is reached.

The basic rules for using an NOL are:

  1. Applying the money toward any taxable income from the two prior tax years will result in an instant tax refund. You can skip this step and move on to the next one instead. If you do, make sure to include a statement in your tax return for the year the NOL was created that details the waiver.
  2. Apply the amount against any taxable income for the subsequent 20 years, reducing the amount of taxable income for those years.
  3. Any remaining NOL is cancelled after 20 years.

Since the time value of money principle states that the tax savings in these periods are more valuable than for any tax savings in subsequent periods, using the NOL against the earliest applicable periods makes financial sense.

Use NOLs in the order they were generated if they are being generated over several years. In other words, the oldest NOL should be used up fully before the next-oldest NOL is accessible. This strategy lessens the possibility that a NOL may be cancelled by the previously mentioned 20-year rule.

The Section 382 Limitation

A net operating loss might be viewed as a significant asset because it can be utilized to immediately lower the amount of taxable income. If a company buys an entity with a NOL, it shouldn't be for that purpose alone because the Internal Revenue Service has put restrictions on how an acquired NOL can be used. Section 382 of the Internal Revenue Code details the restriction. Section 382 declares:

  • If a company with a NOL experiences a change in ownership of at least 50%
  • Only that portion of the NOL that results from multiplying the stock of the acquired firm by the long-term tax-exempt bond rate may be used by the acquirer in each succeeding year.
  • Despite this limitation, a substantial NOL can affect the price paid by an acquirer to the shareholders of an acquiree since it affects the net-of-tax cash flows that an acquirer will obtain from the ongoing performance of an acquiree.

Maximizing Your Loss Deduction

Timing is key to maximizing your net operating loss deduction. Using the temporary net operating loss carryback is a means to retroactively lower your taxable income and receive a cash refund if you've paid taxes on your profits in recent years. It might be better to use the deduction later if you anticipate larger profits and a lower tax bracket in the future.

With the passage of the CARES Act and the Tax Cuts and Jobs Act over the past four years, the carryforward and carryback provisions underwent considerable alteration. Additional adjustments are also likely with a new administration. When preparing your return, if you want to claim a net operating loss deduction, review the most recent tax news online.

Because of the significant value of this deduction and the new rules, you should prepare your approach with an accountant. They are able to recognize deductions and determine when it would be best for your company to claim them.

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