Carry over

What Is Carry Over?

"Carry over" in finance and accounting refers to the practice of transferring an unused financial item, such as a loss, deduction, or credit, from one accounting period to a future period. This mechanism allows entities to utilize certain financial benefits that could not be fully applied in the period they originated, thereby influencing future taxable income or financial results. The concept is a fundamental aspect of financial accounting and tax regulations, ensuring a more equitable and accurate representation of an entity's long-term financial performance. This often applies to tax-related items like net operating loss (NOL) and capital losses, but can also extend to other unused allowances or balances.

History and Origin

The concept of carrying over losses has deep roots in tax legislation, designed to smooth out the impact of fluctuating business profitability. In the United States, the ability to use losses to offset income earned in other years dates back to the Revenue Act of 1918, which initially permitted a one-year carryback and a one-year carryforward for losses. Over time, these provisions have been adjusted multiple times by legislative acts to address economic conditions and policy goals. For example, periods have varied, with some laws allowing for longer carryback or carryforward periods, while others have imposed limitations or eliminated carrybacks entirely, such as aspects of the Tax Cuts and Jobs Act of 2017 and subsequent modifications by the CARES Act of 2020.¹¹,¹⁰ Such adjustments reflect ongoing efforts to balance tax fairness with economic incentives and government revenue needs.

Key Takeaways

"Carry over" is the process of transferring unused financial items from one accounting period to a future period.
Common items that can be carried over include net operating losses, capital losses, and certain tax credits.
The primary purpose of carryovers is to allow businesses and individuals to offset future tax liability, promoting tax fairness across different periods.
The rules governing carryovers, including duration and limitations, are defined by specific tax code and accounting standards.
The future realization of carried-over benefits often impacts a company's deferred tax assets on its balance sheet.

Interpreting the Carry Over

Understanding the implications of a carry over involves recognizing its impact on future financial obligations and potential tax benefits. When an entity has a significant carry over, particularly in the form of losses, it implies that future taxable income can be reduced. This is crucial for tax planning and can significantly affect a company's effective tax rate over multiple periods.

The value of these carryovers, particularly tax loss carryforwards, is a recognized asset that can reduce a company's future tax payments.⁹ However, the actual benefit realized depends on the entity's ability to generate sufficient future profits against which these carryovers can be applied. Accountants and financial analysts evaluate the probability of realizing these benefits, often reflected through the recognition of deferred tax assets on the financial statements. If it's not "more likely than not" that a deferred tax asset will be realized, a valuation allowance may be required to reduce the asset's reported value.⁸

Hypothetical Example

Imagine a small business, "InnovateTech," experiences a challenging year in 2024 and reports a net operating loss (NOL) of $100,000. Under current tax laws, this NOL can be carried over indefinitely to offset future taxable income.

In 2025, InnovateTech turns a corner and achieves a taxable profit of $60,000. Without the carry over provision, the company would owe taxes on this full $60,000 profit. However, because of the NOL carry over from 2024, InnovateTech can offset $48,000 (80% of $60,000, assuming a common limitation on NOL deduction for a given year) of its 2025 profit with the carried-over loss.

Calculation:

2025 Taxable Income: $60,000
NOL Carry Over applied (80% of $60,000): $48,000
Remaining Taxable Income in 2025: $60,000 - $48,000 = $12,000
Remaining NOL Carry Over for future years: $100,000 (initial NOL) - $48,000 (used) = $52,000

InnovateTech's tax liability for 2025 is significantly reduced due to the carry over. The remaining $52,000 NOL can continue to be carried over to future profitable years until it is fully utilized.

Practical Applications

The concept of carry over has several practical applications across different facets of finance:

Tax Compliance and Planning: Carryovers are most commonly associated with tax regulations, allowing individuals and corporations to apply tax deductions, tax credits, or losses from one year against income in subsequent years. This includes Net Operating Losses (NOLs) and capital losses, which can significantly reduce future taxable income. The specific rules regarding carrybacks and carryforwards for NOLs have changed over time with legislative acts like the Tax Cuts and Jobs Act of 2017 and the CARES Act of 2020.⁷
Financial Reporting: Companies recognize the potential future benefits of carryovers as deferred tax assets on their balance sheet. These assets represent the reduction in future tax payments that will result from deductible temporary differences and carryforwards. The accounting treatment of these items follows accounting principles such as ASC 740, which governs how companies account for income taxes in their financial statements.⁶
Business Operations and Investment Decisions: For businesses, the availability of carryovers can influence operational and investment strategies. Companies with substantial loss carryovers might undertake new projects or acquisitions knowing that future profits can be shielded from taxes, effectively increasing the cash flow generated by those profits. The valuation of such carryforwards is an important area of financial analysis for investors.⁵

Limitations and Criticisms

While carryovers offer significant benefits by promoting tax equity and stability for businesses, they also come with limitations and criticisms:

Realization Uncertainty: The primary limitation of a carry over, particularly a tax loss carryforward, is the uncertainty of its future realization. A company must generate sufficient taxable income in future periods to utilize the carry over. If a business continues to incur losses or ceases operations, the carry over may expire unused, rendering it worthless. Accounting standards, specifically Generally Accepted Accounting Principles (GAAP) under ASC 740, require companies to establish a valuation allowance if it is "more likely than not" that a deferred tax asset from a carry over will not be realized.⁴
Expiration Periods: Although some carryovers (like federal NOLs post-2017 TCJA) can be carried forward indefinitely, many jurisdictions or specific types of carryovers (e.g., capital losses) have finite expiration periods. If the carry over is not utilized within this timeframe, it is lost.
Ownership Changes: Tax laws often impose limitations on the use of carryovers after significant changes in a company's ownership (e.g., Section 382 of the U.S. Internal Revenue Code). These rules are designed to prevent "loss trafficking," where profitable companies acquire struggling companies primarily to exploit their unused losses.
Complexity and Financial Reporting: The accounting for carryovers can be complex, involving detailed analysis of future profitability and the application of intricate tax laws. This complexity can sometimes make it challenging for external stakeholders to accurately assess a company's true financial health and future tax liability.³

Carry Over vs. Carry Forward

While "carry over" and "carry forward" are often used interchangeably in general financial discussions, particularly concerning tax losses, it's helpful to clarify their nuances.

Carry Over: This is the broader term, encompassing the general concept of transferring an unused financial item from one period to another. It includes both "carry forward" and "carry back."
Carry Forward: This specifically refers to moving an unused amount (e.g., a loss, deduction, or credit) to a future tax or accounting period to offset future income or reduce future tax liability. For example, a net operating loss from 2024 carried forward to offset income in 2025, 2026, and so on.

The confusion arises because, especially after recent tax reforms in some jurisdictions, "carry forward" is often the only remaining option for many types of losses, making it synonymous with "carry over" in common parlance. Historically, "carry back" (applying a current loss to a prior profitable period to claim a refund) was also a common practice, but its availability has become more restricted for many taxpayers.²

FAQs

What types of financial items can typically be carried over?

The most common items that can be carried over are net operating loss (NOLs), which occur when a business's business expenses exceed its revenue, and capital losses that exceed capital gains in a given year. Additionally, certain tax credits may have carry over provisions.

How does "carry over" benefit businesses?

"Carry over" provisions benefit businesses by allowing them to smooth out their taxable income over time. If a business incurs a loss in one year, it can use that loss to reduce its tax liability in profitable future years, rather than losing the benefit of those losses entirely. This promotes fairness and encourages long-term investment.

Are there limits to how long an item can be carried over?

The duration for which an item can be carried over varies depending on the type of item and the specific tax laws of the jurisdiction. For instance, in the U.S., net operating losses incurred after 2017 can generally be carried forward indefinitely, though their deduction in any given year may be limited.¹ Other items, like capital losses for individuals, have specific limits on annual deductions and may also have expiration periods.

Does a carry over always guarantee a tax benefit?

No, a carry over does not always guarantee a tax benefit. The benefit is contingent on the entity generating sufficient taxable income in future periods against which the carry over can be applied. If the entity continues to incur losses or does not generate enough profit before the carry over expires (if it has an expiration period), the potential tax benefit may never be realized. This uncertainty is reflected in financial reporting through concepts like a valuation allowance for deferred tax assets.