Carryback

What Is Carryback?

Carryback, within the realm of tax planning and corporate finance, refers to a provision in tax law that allows a business or individual to apply a current year's net operating loss (NOL) against taxable income from previous years. This effectively reduces the previously reported taxable income for those past periods, potentially resulting in a tax refund for taxes already paid. The concept of carryback is designed to smooth out a taxpayer's income over the business cycle, ensuring that businesses are taxed on their long-term profitability rather than on fluctuating annual results.

History and Origin

The ability to use losses to offset income from other years has been a feature of U.S. federal tax law since the Revenue Act of 1918, which initially allowed a one-year carryback and one-year carryforward of losses.³¹ Over the decades, the specific rules governing carryback periods have varied significantly. Before the Tax Cuts and Jobs Act (TCJA) of 2017, the general rule allowed taxpayers to carry back net operating losses for two years and carry them forward for 20 years.³⁰

However, the TCJA brought a substantial change, generally eliminating the ability to carry back NOLs for most taxpayers with losses arising in tax years ending after December 31, 2017.²⁸, ²⁹ This shift was partly intended to raise revenue and simplify the tax code.²⁷ A notable, albeit temporary, reversal occurred with the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020. In response to the economic fallout of the COVID-19 pandemic, the CARES Act retroactively allowed NOLs from tax years 2018, 2019, and 2020 to be carried back for up to five years.²⁵, ²⁶ This temporary measure provided a significant liquidity injection for many businesses facing immediate financial strain. As of tax years beginning after 2020, the general rule of no carryback largely returned, with exceptions for certain types of losses, such as farming losses, which retain a two-year carryback period.²³, ²⁴

Key Takeaways

• A carryback allows businesses to apply current tax losses against prior years' taxable income to potentially receive a tax refund.
• The primary purpose of a carryback is to smooth out tax liability over multiple periods, accounting for fluctuating business performance.
• Federal tax laws regarding carrybacks have changed significantly, notably with the Tax Cuts and Jobs Act (TCJA) and the temporary provisions of the CARES Act.
• Currently, the ability to carry back net operating losses is largely limited for most taxpayers, with some exceptions like farming losses.
• Utilizing a carryback can provide immediate cash flow to a business experiencing a loss.

Formula and Calculation

The calculation of a net operating loss (NOL) that can be subject to a carryback (when permitted) involves specific adjustments to a taxpayer's financial figures for the loss year. The Internal Revenue Service (IRS) provides detailed guidance on this process in publications such as IRS Publication 536.²¹, ²²

While the full calculation of an NOL can be complex, involving numerous adjustments to initial loss figures, the core idea is that the NOL amount is the excess of allowed tax deductions over taxable income for a given taxable year.

If a carryback is allowed for a particular NOL, the formula for determining the tax benefit is:

Where:

• (\text{NOL Applied in Year } i) represents the portion of the net operating loss applied to the taxable income of a previous year, (i).
• (\text{Tax Rate in Year } i) is the tax rate applicable to the income in that specific previous year, (i).
• (n) is the number of years the NOL is carried back.

For example, if a business could carry back an NOL of $100,000 to a year when its tax rate was 35%, the tax benefit would be $35,000.

Interpreting the Carryback

Interpreting the carryback provision primarily involves understanding its impact on a company's financial health and strategic decisions. For businesses facing a significant loss, the ability to carry back that loss means they can reclaim taxes paid in previous profitable periods. This immediate influx of cash can be crucial for maintaining operations, covering expenses, and avoiding further financial distress.²⁰ It essentially allows a business to average its income and tax obligations over several years, recognizing that profitability is not always linear.

From an accounting perspective, a carryback impacts a company's balance sheet and income statement by reducing past tax expenses and generating a receivable from the tax authority. The value of a carryback is highest when it can offset income from years with higher effective tax rates, as this maximizes the potential refund. This capability provides a degree of financial flexibility and can serve as a form of "automatic stabilizer" during economic downturns, offering relief without requiring new legislative action.¹⁹

Hypothetical Example

Consider a manufacturing company, "Widgets Inc." In 2023, Widgets Inc. experiences a challenging year due to supply chain disruptions and reduced demand, resulting in a net operating loss of $500,000. Under current U.S. federal tax law, Widgets Inc. generally cannot carry back this loss.

However, let's imagine a scenario where the law temporarily allowed a five-year carryback, similar to the CARES Act provisions.

1. Determine the Loss Year: Widgets Inc. has a $500,000 NOL in 2023.
2. Identify Carryback Years: Under the hypothetical five-year rule, Widgets Inc. could look back to its profitable years from 2018 to 2022.
3. Apply NOL to Earliest Profitable Year:
   • In 2018, Widgets Inc. had a taxable income of $200,000, taxed at a rate of 21%.
   • Widgets Inc. would apply $200,000 of its 2023 NOL to offset the 2018 income.
   • This would generate a tax refund for 2018.
4. Carry Remaining NOL Forward (or to next carryback year):
   • Remaining NOL: $500,000 - $200,000 = $300,000.
   • In 2019, Widgets Inc. had a taxable income of $150,000, also taxed at 21%.
   • Widgets Inc. would apply $150,000 of the remaining 2023 NOL to offset the 2019 income.
   • This would generate a tax refund for 2019.
5. Continue Until NOL is Exhausted or Carryback Period Ends: The remaining $150,000 NOL from 2023 would then be applied to 2020 taxable income, until the entire $500,000 NOL is utilized, or the carryback period expires. Any remaining unutilized NOL would then be carried forward to future profitable years (known as a carryforward).

This process allows Widgets Inc. to recover taxes paid in prior years, providing much-needed capital during a difficult period.

Practical Applications

While the general federal allowance for carrybacks is currently limited, understanding its practical applications is vital for businesses and tax professionals. When permitted, carryback provisions offer a critical mechanism for:

• Cash Flow Management: Businesses experiencing a loss can receive an immediate tax refund by carrying back losses. This direct injection of capital can help cover operating expenses, meet payroll, or fund essential investments, particularly during economic downturns. This provides much-needed liquidity when external financing might be scarce.¹⁸
• Income Smoothing: The ability to offset current losses against past profits helps to smooth a company's overall profitability for tax purposes. This aligns the tax treatment with the economic reality that business profitability often fluctuates over time due to various factors like the business cycle or industry-specific challenges.¹⁷
• Mitigating Risk: For industries with volatile revenues or high initial investment costs, such as technology or pharmaceuticals, the assurance of a potential carryback mechanism can mitigate some entrepreneurial risk. It provides a safety net, knowing that taxes paid during successful years can be partially recovered if subsequent years incur significant losses.¹⁶
• Strategic Financial Planning: When carrybacks are an option, they become a key consideration in a company's tax planning. Businesses must assess whether to carry back losses for an immediate refund or carry them forward to offset future taxable income, depending on their financial projections and expected future tax rates.

In the U.S., federal law currently allows for Net Operating Losses (NOLs) to be carried forward indefinitely, but generally prohibits carrybacks, with certain exceptions such as farming losses.¹⁴, ¹⁵ However, during periods of economic crisis, temporary carryback provisions, like those in the CARES Act of 2020, have been implemented to provide rapid financial relief.¹², ¹³

Limitations and Criticisms

Despite the benefits a carryback can offer, there are several limitations and criticisms associated with these provisions:

• Current Restrictions: For most U.S. federal taxpayers, the ability to carry back net operating losses has been eliminated under the Tax Cuts and Jobs Act (TCJA) of 2017 for losses arising after 2017.¹⁰, ¹¹ While temporary exceptions, like those under the CARES Act, have occurred, the general rule is now a carryforward only for an indefinite period, subject to an 80% taxable income limitation for losses arising after 2017.⁹ This significantly restricts the immediate liquidity benefit that carrybacks once provided.
• Complexity: The rules surrounding NOL calculations and their application (whether via carryback or carryforward) can be highly complex, especially for businesses with multiple entities or international operations. Taxpayers often require professional guidance to navigate IRS publications like IRS Publication 536 and ensure compliance.
• Economic Stimulus Effectiveness: Some analyses suggest that adjusting carryback rules may not be the most effective form of fiscal policy for economic stimulus. Firms experiencing losses during a downturn might not be in a position or have the desire to undertake new investments, even with the promise of a tax refund. The economic uncertainty can overshadow the incentive provided by loss carrybacks.⁸
• Potential for Abuse: Historically, there have been concerns that some firms might attempt to "engineer paper losses" to benefit from carrybacks, making it difficult for tax authorities to detect such behavior.⁷ Regulatory measures and limitations are often put in place to prevent such scenarios.
• State-Level Variation: While federal law sets a precedent, state income tax laws often vary in their treatment of net operating losses and carrybacks. Many states either conform to federal provisions or have their own rules, which can add another layer of complexity for businesses operating across different jurisdictions.⁶

Carryback vs. Carryforward

The terms "carryback" and "carryforward" both relate to how a business or individual utilizes a net operating loss (NOL) to reduce tax liability, but they differ in the direction and timing of the loss application.

A carryback allows a taxpayer to apply a current year's NOL to offset taxable income from past years. This can result in a refund of taxes previously paid, providing an immediate cash infusion to the taxpayer. Historically, the carryback period in the U.S. was typically two years, although temporary expansions have occurred.

Conversely, a carryforward allows a taxpayer to apply a current year's NOL to offset taxable income in future years. This reduces future tax obligations rather than generating an immediate refund. Under current U.S. federal law, net operating losses generally can only be carried forward indefinitely, with no carryback allowed for most taxpayers, though a limitation of 80% of taxable income applies to the amount that can be offset in any given future year.⁵

The primary distinction lies in the timing of the tax benefit: a carryback offers immediate liquidity by reclaiming past taxes, while a carryforward provides a future tax reduction.

FAQs

What is a net operating loss (NOL)?

A net operating loss (NOL) occurs when a business's or individual's allowable tax deductions exceed their taxable income for a given tax year. It signifies that the business operated at a loss for tax purposes.

Can all businesses use a carryback for their losses?

No. Under current U.S. federal tax law, most businesses cannot carry back net operating losses generated in tax years ending after 2017. The primary method for utilizing an NOL is now a carryforward to future years. There are specific exceptions, such as farming losses, which may still qualify for a limited carryback period.⁴

How does a carryback benefit a business?

When permitted, a carryback allows a business experiencing a loss to amend previous tax returns and reduce its past taxable income. This can result in a tax refund for taxes paid in those earlier profitable years, providing valuable cash flow. This immediate benefit can help a company manage expenses and survive financial difficulties.

What was the CARES Act's impact on carrybacks?

The CARES Act, passed in 2020, temporarily and retroactively reinstated a five-year carryback period for net operating losses incurred in tax years 2018, 2019, and 2020.², ³ This was a temporary measure to provide economic relief during the COVID-19 pandemic. After 2020, the general rule of no carryback for most NOLs returned.

Where can I find detailed information about NOLs and carrybacks?

The Internal Revenue Service (IRS) provides comprehensive guidance on net operating losses for individuals, estates, and trusts in IRS Publication 536.¹ Businesses should also consult the relevant tax code sections and consider seeking advice from a qualified tax professional due to the complexity of the rules.