Introduction
Net operating losses (NOLs) allow businesses and noncorporate taxpayers to use a tax-year loss to reduce tax in other years. NOL rules have changed materially in recent years (TCJA, CARES Act, Inflation Reduction Act), so careful tracking and planning are essential. This article explains what an NOL is, how to calculate and apply one, the current legal limits and exceptions, and concrete, practical steps for using NOLs in tax planning.
What is a Net Operating Loss (NOL)?
– Definition: An NOL arises when allowable tax deductions for a tax year exceed taxable income for that year. For federal tax purposes the result is a negative taxable income that, following IRS procedures, may be carried forward (and historically sometimes carried back) to offset taxable income in other years.
– Who it affects: Corporations, partnerships (through partners), sole proprietors, and other noncorporate taxpayers (individuals, estates, trusts). Calculation and use differ by taxpayer type; individuals typically use IRS Publication 536 worksheets.
How to Calculate an NOL — Step-by-step (practical)
1. Compute taxable income before the NOL:
• Start with your regular taxable income computation for the tax year.
2. Add back or adjust items required by IRS rules:
• Follow the steps in IRS Publication 536 (individuals, estates, trusts) or applicable corporate guidance. These include adjustments for nondeductible items and special deductions.
3. Identify the excess of deductions over income:
• If deductions exceed income after adjustments, that excess is the tentative NOL.
4. Make required NOL-specific adjustments:
• Exclude the capital loss carryback/carryforward rules as required, and follow the worksheet items in Pub 536 (or corporate instructions).
5. Record the NOL amount and its tax year of origin:
• You must track the origin year(s) because carryforward application and any limitations may depend on the origination year.
Key example (illustrative)
– Year 1: NOL of $500,000.
– Year 2 taxable income (before NOL): $400,000.
– For tax years beginning after 2020 the NOL deduction is limited to 80% of taxable income (computed before the NOL deduction). So:
• 80% × $400,000 = $320,000 allowable NOL deduction in Year 2.
• Year 2 tax remains on $80,000 ($400,000 − $320,000).
• Remaining NOL carryforward: $500,000 − $320,000 = $180,000.
Historical context and major statutory changes
– Pre-2017 (pre-TCJA): NOLs could generally be carried back two years and carried forward up to 20 years.
– TCJA (Tax Cuts and Jobs Act, 2017): Eliminated the two-year carryback for most taxpayers, allowed indefinite carryforwards, and limited NOL deduction to 80% of taxable income for losses arising in tax years beginning after 2017.
– CARES Act (2020): Temporarily relaxed rules to provide pandemic relief:
• Allowed five-year carrybacks for NOLs arising in 2018, 2019, and 2020 (subject to conditions).
• Suspended the 80% limitation for certain years, allowing full offset for eligible NOLs carried back or used in 2018–2020 in many cases.
• These CARES Act relief provisions were temporary and primarily applied to NOLs from specified years.
– Inflation Reduction Act (2022) and subsequent guidance: Made additional technical changes and left the post-TCJA framework largely intact: indefinite carryforwards for most NOLs and the 80% limitation for tax years beginning after 2020.
Current federal rules (summary)
– Carryforwards: NOLs generally can be carried forward indefinitely until used up.
– Carrybacks: Generally disallowed for recent losses, with limited exceptions (for example, certain farming losses and any temporary special provisions like the CARES Act that applied to specific years). Check current law for temporary or sector-specific exceptions.
– 80% limitation: For tax years beginning after 2020, an NOL deduction generally cannot exceed 80% of taxable income (computed without regard to the NOL deduction).
– Basis and ordering: If multiple NOLs from different years exist, track their origin years for ordering and application; different rules may apply for NOLs originating in different periods.
– Excess business loss limitation (noncorporate taxpayers): Noncorporate taxpayers are subject to a limit on “excess business losses” (disallowed losses are treated as NOLs carried forward). Thresholds are indexed annually (example: for 2024, the threshold was $305,000 for single taxpayers and $610,000 for joint filers—verify current-year amounts). These amounts are suspended or modified by legislation from time to time; check the IRS and current law.
– Ownership change limits (IRC §382): If a corporation undergoes an “ownership change” (a greater than 50% change in ownership over a rolling three-year period by 5% shareholders), the annual use of pre-change NOLs is generally limited by Section 382. The limit equals the corporation’s value immediately before the ownership change multiplied by a prescribed long-term tax-exempt rate—meaning the NOL usage may be drastically reduced after ownership change events, so pre-transaction tax planning is vital.
Practical steps and checklist for businesses and taxpayers
1. Compute and document the NOL precisely
• Use IRS Publication 536 (individuals/estates/trusts) or corporate tax templates and worksheets; keep working papers evidencing how the NOL was determined.
2. Track origin year(s) and carryforward balance
• Maintain a clear schedule showing each-year NOL amounts, amounts used, and remaining balances. If you have pre-2018 NOLs, track them separately from post-2017 NOLs because rules differ.
3. Apply the 80% limitation properly
• Compute the 80% allowable deduction based on taxable income before the NOL deduction (and other required pre-deduction adjustments). Consult guidance about whether other deductions (e.g., Sec. 199A QBI) are excluded before applying the 80% limitation.
4. Watch for ownership changes and §382 traps
• If a transaction could trigger an ownership change (sale, issuance of stock), obtain a pre-transaction valuation and run a §382 calculation. Consider structuring the deal to preserve NOL value when possible.
5. Consider state NOL rules
• State treatment of NOLs varies widely (e.g., carryforward periods, percentage limitations, conformity to federal changes). Don’t assume federal rules automatically apply at the state level.
6. Account for deferred tax assets and valuation allowances
• For financial reporting, NOLs create deferred tax assets (DTAs). Evaluate whether a valuation allowance is needed under ASC 740 if it is more likely than not that some or all the DTA will not be realized.
7. File the appropriate forms and elections
• Historically, forms such as Form 1045 (Application for Tentative Refund), Form 1139 (corporate tentative refund), or amended returns were used to carry back NOLs when allowed. For excess business loss suspensions, Form 461 (Limitation on Business Losses) and worksheets may apply. Check current-year instructions and IRS guidance.
8. Preserve documentation for audits
• Maintain tax returns, supporting schedules, carryforward worksheets, and any valuations or opinions used to justify carryforwards and §382 calculations.
9. Consult a tax professional for complex issues
• Transactions (ownership changes, mergers, large carryforwards), cross-border issues, consolidated returns, partnership-level losses, or significant state issues warrant specialist advice.
Common traps and planning considerations
– Don’t assume carrybacks: Most NOLs now cannot be carried back; planning that assumed refunds by carrying back losses can be costly.
– Section 382 can dramatically limit value: If you plan a sale or capital raise, plan for §382 consequences early.
– State conformity differs: Some states limit carryforwards or don’t follow federal 80% treatment. Factor state tax cash flows into planning.
– Watch the timing of income and deductions: Because of the 80% limitation, it can be optimal to manage other timing or election issues to maximize NOL recoveries.
– For individuals/business owners: Be aware of the excess business loss rules; losses in excess of the threshold become NOLs carried forward rather than immediate deductions.
Accounting and reporting
– Deferred tax asset recognition: NOL carryforwards typically create a deferred tax asset equal to the tax effect of the NOL, subject to valuation allowance analysis under GAAP (ASC 740).
– Tax return reporting: Use the appropriate schedules or return lines to claim an NOL deduction and report carryforwards. Keep supporting worksheets with the return.
Example revisited — Daratech Solutions (practical)
– Year 1: Daratech has taxable net losses that produce an NOL of $500,000 (origin year documented).
– Year 2: Daratech has taxable income before NOL of $400,000.
• 80% limit: allowable NOL deduction = 80% × $400,000 = $320,000.
• Remaining taxable income = $80,000.
• Remaining NOL carryforward = $500,000 − $320,000 = $180,000 to use in future years (subject to the same 80% limit each year).
– Accounting: Record a deferred tax asset for the tax benefit, evaluate the need for a valuation allowance, and track remaining NOLs on a schedule.
When to get professional help
– If you have large carryforwards, a potential ownership change, multi-state activity, crossing international borders, or consolidated return issues, consult a tax advisor with experience in NOL and §382 planning.
– A CPA or tax attorney can run §382 analyses, valuation scenarios, and prepare elections and forms necessary to protect NOL value.
Bottom line
NOLs can provide meaningful tax relief by shifting losses to offset future taxable income, improving cash flow when profits return. Recent law changes mean NOLs are generally carried forward indefinitely but subject to an 80% limit of taxable income in most post-2020 years and are generally not carried back. Proper calculation, careful tracking by origin year, awareness of ownership-change rules (IRC §382), and coordination with state rules are essential for preserving and using NOLs effectively.
Sources and further reading
– Investopedia — Net Operating Loss (NOL):
– Internal Revenue Service, Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts:
– Internal Revenue Service instructions and forms (search for Form 461, Form 1045, Form 1139 as applicable):
– Congressional Research Service, “Tax Treatment of Net Operating Losses (NOLs)”: (CRS reports on NOLs)
– Tax Foundation, “Net Operating Loss Carryforward” and related analyses
– Legislative sources: Tax Cuts and Jobs Act (TCJA, 2017), CARES Act (2020), Inflation Reduction Act (2022)
– Practical guidance on Section 382 and ownership change limits: GHJ Advisors, The Tax Adviser articles on IRC §382
(1) produce a ready-to-use NOL carryforward worksheet template; 2) run a sample multi-year projection showing the impact of 80% limitations and §382 under hypothetical ownership-change scenarios; or 3) summarize state-by-state NOL conformity highlights.)
(Continuing from previous discussion)
Restrictions After Ownership Changes (Section 382) — expanded
– What Section 382 does: When a corporation undergoes an “ownership change” (generally defined as a more-than-50-percentage-point increase in stock ownership by 5%-or-more shareholders over a rolling three-year testing period), the ability to use pre-change NOLs to offset post-change taxable income is limited. The annual usable amount is generally the target corporation’s value immediately before the ownership change multiplied by the long-term tax-exempt rate (the “Section 382 limitation”), subject to adjustments.
– Practical effect: Even if a company has a large pre-change NOL, a change-in-control transaction can drastically slow the pace at which those losses reduce taxable income going forward.
– Practical step: Before completing equity financings, mergers, or major shareholder changes, model the Section 382 limit and consult counsel/accountants to see if transaction structures can preserve more NOL value.
Practical Steps to Calculate and Use an NOL
Below is a step-by-step process you can follow as a practical checklist. This is a general approach—individual circumstances and entity types (corporation vs. noncorporate) affect details.
1. Identify the loss year
– Determine the tax year in which deductions exceed income and quantify the excess.
2. Prepare the preliminary NOL amount
– For individuals/noncorporate taxpayers: start with taxable income (or loss) per return before deducting the NOL itself, then add back or adjust items required by IRS Publication 536 (exemptions, non-business deductions, capital loss carrybacks, etc.). Use IRS Publication 536 worksheet for details.
– For corporations: start with net operating loss per Form 1120 rules, making statutory adjustments (some non-tax book expenses may differ).
3. Determine which law applies to that NOL
– Losses arising in tax years beginning after 2017 generally follow TCJA rules: indefinite carryforward, 80% of taxable income limitation for tax years beginning after 2020 (subject to exceptions).
– Losses arising in 2018–2020: CARES Act temporarily allowed 5-year carrybacks and removed the 80% limitation for those returns, but these were transitional and may require elections.
– Track the origination year because different rules (carryback eligibility, 80% limit) may apply.
4. Check carryback availability
– Generally, carrybacks are not available for post-TCJA NOLs, except for special rules (e.g., certain farming losses) or historical CARES Act elections for eligible years.
5. Apply the 80% taxable income limitation (if applicable)
– For tax years beginning after 2020, an NOL deduction is limited to 80% of taxable income computed before the NOL deduction (and before certain other specified deductions). If your taxable income is T and your available NOL is L, maximum NOL allowed = 0.80 × T. The remainder carries forward indefinitely.
6. Account for excess business loss rules for noncorporate taxpayers
– For noncorporate taxpayers (individuals, estates, trusts) through 2028, excess business loss (EBL) rules may disallow part of current-year business loss and require it to be treated as an NOL carryforward instead. Verify thresholds (indexed annually).
7. Track state treatment
– State NOL rules vary widely. Confirm whether your state conforms to federal NOL carryforward periods, percentage limitations, or disallows certain federal NOLs entirely.
8. Maintain documentation & reporting
– Keep worksheets showing origination year, computation steps, and elections made (e.g., CARES Act carryback elections if any). Report NOL use on tax return lines/schedules and attach necessary forms.
Examples (practical numeric illustrations)
1) Applying the 80% limitation (post-2020 NOL usage)
– Facts: Corporation Alpha has a post-2020 NOL carryforward of $1,000,000. In tax year 2025 it has taxable income before NOL of $500,000.
– Compute: 80% limitation = 0.80 × $500,000 = $400,000. Alpha may use $400,000 of NOL in 2025; $600,000 carries forward indefinitely.
2) Simple two-year startup example (similar to earlier Daratech example, with 80% limit)
– Year 1: Daratech incurs $500,000 NOL (post-2020 loss).
– Year 2: Taxable income before NOL = $400,000.
– 80% limit = 0.80 × $400,000 = $320,000 allowed NOL in Year 2. Taxable income after NOL = $400,000 − $320,000 = $80,000. Remaining NOL carryforward = $500,000 − $320,000 = $180,000 (carried forward indefinitely).
3) Section 382 ownership change cap (conceptual)
– Facts: Corporation Beta has $2,000,000 of pre-change NOLs. Immediately pre-change fair market value of Beta’s equity = $1,000,000. The long-term tax-exempt rate = 3.0%.
– Annual limit = $1,000,000 × 3.0% = $30,000 per year.
– Consequence: Beta can use only $30,000 of the pre-change NOLs each post-change year (subject to indexation and other adjustments), so the NOL recovery is spread over many years.
4) Noncorporate excess business loss (EBL) example (2024 thresholds for illustration)
– Facts: Individual taxpayer has business losses of $400,000 in 2024 and other income such that the EBL threshold is $305,000 (single filer hypothetical).
– Compute: Excess business loss = $400,000 − $305,000 = $95,000. That $95,000 is disallowed for 2024 and treated as an NOL carryforward to 2025.
Recordkeeping, Reporting and Forms
– Corporations: report NOL carryforwards and uses on the corporate tax return (Form 1120 and related schedules); track separate NOL pools by year if required.
– Individuals/estates/trusts: use IRS Publication 536 for computing NOLs; report on Form 1040 schedules and attach worksheets per IRS guidance.
– Elections: CARES Act carrybacks (for eligible years) required positive affirmative elections to waive carrybacks in some situations—keep documentation.
– Keep contemporaneous workpapers: detailed year-by-year NOL schedules, supporting financial statements, and documentation of any elections or carryback claims.
State considerations
– Many states do not conform exactly to federal NOL rules. Examples:
• Some states limit the carryforward period (e.g., 15 or 20 years).
• Some states disallow federal NOL deductions or limit the percentage of taxable income that state NOLs can offset.
– Practical step: For multistate businesses, maintain separate NOL tracking at the state level and consult state-specific tax guidance.
Tax Planning Strategies Involving NOLs
– Timing of income and deductions: If feasible, accelerate deductions or defer income in years where the 80% limit would otherwise restrict use (coordinate with cash-flow needs).
– Consider M&A implications early: In an acquisition scenario, quantify Section 382 consequences and structure transactions (stock vs. asset deals) with NOL availability in mind.
– Use tax-attribute carryback elections (when available): For eligible historic years (e.g., CARES Act-era options), consider carryback elections to obtain refunds and improve liquidity.
– Watch for EBL traps: For individual business owners, large current-year business losses may be disallowed as EBLs and be postponed as NOL carryforwards.
– State planning: Evaluate whether state elections or apportionment choices affect NOL absorption.
Common Pitfalls and Warnings
– Treating federal and state NOLs the same: state regimes often differ—don’t assume conformity.
– Ignoring ownership change rules: failing to model Section 382 can result in overvaluing NOLs in transaction models.
– Missing origination-year tracking: because different rules apply based on the year of origination, good bookkeeping of NOL years is essential.
– Overlooking documentation or required elections: some relief provisions require affirmative elections; failing to timely elect may forfeit an opportunity.
Additional Historical Context (brief recap)
– Pre-2017 (pre-TCJA): NOLs could generally be carried back two years and forward up to 20 years.
– TCJA (2017): eliminated the two-year carryback for most NOLs, allowed indefinite carryforwards, and set a limitation of 80% of taxable income for NOLs originating in tax years beginning after 2017 (timing rules apply).
– CARES Act (2020): as pandemic relief, allowed 2018–2020 NOLs to be carried back up to five years and temporarily suspended the 80% limitation for taxable years 2018–2020 (permitted 100% offset). Many taxpayers made affirmative elections under these rules.
– Post-CARES: rules largely returned to TCJA framework, with the 80% limit applicable for tax years beginning after 2020 and carrybacks generally unavailable (except narrow exceptions).
Further Examples and Illustrations
– Practical M&A illustration: if your startup has $3 million of accumulated NOLs but a potential buyer values your company at $500,000 and the long-term tax-exempt rate is 2.5%, the Section 382 annual cap would be $12,500—tiny relative to $3 million. Buyers and sellers must allocate value to tax attributes and often price the deal accordingly.
– Cash-flow recovery illustration: a company with large NOLs from pandemic-affected years might have used CARES Act carrybacks to obtain immediate refunds and bolster liquidity—an important historical lesson in using temporary relief when available.
Concluding Summary
Net operating losses are a powerful tax attribute that can transform current losses into future tax savings. Post-2017 federal law generally allows indefinite carryforwards but limits yearly usage to 80% of taxable income for NOLs subject to that rule. Historical temporary relief (CARES Act) provided carrybacks and suspended the 80% rule for certain years, but those were transitional. Noncorporate taxpayers face additional rules on excess business losses, and state rules can materially differ from federal treatment. Equally important, ownership changes can severely limit the rate at which pre-change NOLs are used under Section 382, making NOL valuation a critical consideration in financings and M&A.
Practical takeaway: maintain precise, year-by-year NOL schedules, coordinate planning with tax advisors before major transactions or elections, and model the 80% limitation and potential Section 382 caps when forecasting tax liability. With careful planning and recordkeeping, businesses can maximize the value of NOLs and use them strategically to smooth tax burdens across cyclical or start-up years.
Selected resources and further reading
– Internal Revenue Service, Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts:
– Investopedia, “Net Operating Loss (NOL)” (background and practical summaries):
– Congressional Research Service, Tax Treatment of Net Operating Losses (NOLs) (overview & legislative history)
– Tax Foundation, Net Operating Losses (explainers and state-conformity analyses): /
– For Section 382 and ownership-change details, consult specialized guidance or tax-adviser commentary (e.g., The Tax Adviser, GHJ Advisors) and IRS regulations governing ownership changes.
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.