Net Operating LossExplained & Defined

Written By:
Lisa Borga

What is Net Operating Loss?

For companies, a net operating loss (NOL) results from an excess of allowable deductions beyond its taxable income.

NOL from a given period may often be transferred forward to future tax periods to reduce future payments. This process is referred to by the IRS as a loss carryforward.

How NOL Works

An NOL is an asset that will offer a company benefit in future tax periods by reducing its future income tax burden.

A company’s NOL will often be recorded on the general ledger as an asset.

This will be reduced every year in which the company earns a profit to offset the income up to a maximum of 80% of net income.

This will carry forward indefinitely until the account’s balance has been reduced to zero.

This means that, for example, a retail shop may suffer a year of poor sales that result in a significant loss.

If the store’s sales fare better the next year and the store makes a profit that would otherwise place a tax burden on the business, the store can carry forward the prior year’s loss to reduce the tax burden.

How NOL Can Be Calculated

A company’s net operating loss is calculated by finding its taxable income and then subtracting all qualifying deductions.

If the resulting number is negative, then the company has suffered a net operating loss.

Let’s say that a given business earned a taxable income of $1,000,000 and had a qualifying deduction of $1,100,000.

This would result in a net operating loss of $100,000.

Now assume that in the following year, the company earned a profit of $300,000 at a tax rate of 30%.

The company can apply the previous year’s net operating loss to the current year’s taxable income to reduce the current year’s tax burden.

Using a Net Operating Loss

Net operating losses, or as they are sometimes known, net losses, show up on a business’s income statement.

Before 2018 when the Tax Cuts and Jobs Act took effect, businesses were permitted by the IRS to carry their NOLs forward for a period of 20 years to offset future profits or backward for two years to allow previously paid taxes to be refunded.

Most companies preferred to use the carryback rather than the carryforward and receive a refund of the taxes they previously paid because this option was more beneficial than reduced future taxes due to the time value of money.

Although under these rules, losses could only be carried forward for a period of 20 years.

After this, any losses that still remained would expire, and businesses could no longer use these losses to reduce their taxable income.

NOL Carryforward Example

Suppose a company had a net operating loss of $7 million in one year and then an income of $8 million in the next year.

The business could carry this $7 million loss on its balance sheet to be used in the following year to reduce its tax burden.

The business would be limited to 80% of its $8 million income, which would be $6.4 million.

This means that $6.4 million of the $7 million loss could be used to reduce the business’s $8 million in taxable income to $1.6 million, thus reducing the business’s tax liability.

The remaining $600,000 of the net operating loss could be carried forward on the business’s balance sheet to be used in future years until the NOL is completely exhausted.

What is an NOL Carryforward?

Businesses can typically use a net operating loss to offset tax payments in other tax periods by using an IRS tax provision known as NOL carryforward.

By using this provision, a business can offset its taxable income in future years, thus reducing its tax liability in these years.

The intent of the NOL carryforward provision is to give businesses some tax relief when they incur a loss during a tax period.

How Did the TCJA Affect NOL Carryforwards?

The Tax Cuts and Jobs Act (TCJA) eliminated the previous two-year carryback provision for tax years beginning in 2018 unless it is used for specific farming losses.

However, the act does allow NOLs to be carried forward indefinitely.

But, these carryforwards are restricted to 80% of the net income of each ensuing year.

Should a business have an NOL occur in more than one year, net-operating losses must be completely used in the order in which they occurred.

This means the NOL that was incurred first needs to be exhausted before using the next NOL.

Due to the CARES Act, any changes that were put in place by the TCJA did not apply for 2018, 2019, and 2020.

However, as of 2021, these rules do apply. If a business has losses that occurred before 2018, the former tax rules still apply, and any losses remaining after 20 years expire.

How To Account for NOL Carryforwards

Companies record NOL carryforwards as assets in their general ledger.

This creates a deferred tax asset which can then be used in future years to offset net income.

Each year this deferred tax asset account can be used to offset up to 80% of the business’s net income for the year until the balance of the account reaches zero.

Limitations on NOL Carryforwards

Non-operating losses are valuable assets due to the fact that they can lower a business’s taxable income in the future.

Because of this, the IRS limits the ability of businesses to acquire another company and use the company for its NOL tax benefits alone.

According to Internal Revenue Code Section 382, when a business with a net operating loss has an ownership change of at least 50%, the company acquiring the business is only permitted to use a portion of the net operating loss in each following year.

Although it still may be beneficial for a company to purchase such a business because it could cause the company’s stockholders to receive more money than they would have if a business with a smaller NOL had been acquired.

Key Takeaways

• The IRS describes a net operating loss as occurring when deductions and losses from all sources are greater than its combined taxable income.
• For income as of 2017, the net operating loss may be indefinitely carried forward to future tax periods until all loss has been recovered. However, this is limited in any given tax period to only 80% of taxable income earned in that period.
• For NOL occurring in 2021 and future tax years, carryback is not an option and instead must be indefinitely carried forward.