Carryforward

What Is Carryforward?

Carryforward, in the realm of tax accounting, refers to the practice of applying a current year's unused tax deduction, credit, or loss against future tax liabilities or income. This mechanism allows taxpayers, whether individuals or corporations, to utilize tax benefits that exceed their current year's taxable income or tax obligations. The most common application of a carryforward involves a net operating loss (NOL), where business deductions exceed gross income, or when capital losses exceed capital gains. The ability to carryforward losses helps smooth out the impact of fluctuating income and expenses over various accounting periods, providing a more balanced picture of long-term profitability and reducing the overall tax burden.

History and Origin

The concept of allowing businesses to manage losses against profits across different years has a long history in tax law, recognizing that business cycles are rarely perfectly aligned with annual tax periods. 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 both a one-year carryback and a one-year carryforward. Over time, these periods have been adjusted by various legislative acts. For instance, prior to the Tax Cuts and Jobs Act (TCJA) of 2017, net operating losses could generally be carried back two years and carried forward for up to 20 years.

However, the TCJA significantly altered these rules, eliminating NOL carrybacks for most taxpayers and limiting the amount of taxable income that could be offset by carryforwards to 80%. This change was enacted to help defray the overall cost of the legislation. A notable, albeit temporary, reversal occurred with the Coronavirus Aid, Relief, and Economic Security (CARES) Act in 2020, which allowed NOLs from 2018, 2019, and 2020 to be carried back up to five years and temporarily suspended the 80% income limitation, allowing losses to fully offset taxable income for those years¹³,. These legislative shifts underscore the dynamic nature of carryforward rules, often influenced by economic conditions and policy objectives.

Key Takeaways

• Carryforward allows certain unused tax deductions, credits, or losses to be applied against future tax liabilities.
• The primary benefit is reducing future tax liability by offsetting future gross income or gains.
• Common carryforwards include net operating losses and excess capital losses.
• Rules for carryforwards, including duration and limitations, are determined by tax authorities and can change with legislation.
• Understanding carryforward provisions is crucial for effective tax planning and financial management.

Formula and Calculation

While there isn't a single universal formula for "carryforward," the calculation often involves determining the amount of a specific loss or deduction that exceeds the current year's limit and then tracking that excess amount to apply in subsequent periods.

For a net operating loss (NOL), the calculation generally involves:

Where:

• Current Year NOL: The amount by which allowable deductions exceed gross income for the current tax year. Taxpayers can refer to IRS Publication 536 for detailed guidance on calculating NOLs for individuals, estates, and trusts,¹².
• Taxable Income of Carryback Years: If carryback is permitted and elected, this is the amount of income offset in prior years.
• Applicable Percentage: The percentage of future taxable income that can be offset by the NOL. This percentage can vary by jurisdiction and legislative changes. For instance, under permanent U.S. law, NOLs carried forward are generally limited to 80% of taxable income¹¹.

For capital losses, the calculation for the carryforward amount is simpler:

Where:

• Total Capital Losses: The sum of all capital losses incurred in the year.
• Total Capital Gains: The sum of all capital gains realized in the year.
• Annual Deduction Limit: The maximum amount of capital losses that can be deducted against ordinary income in a given year (e.g., $3,000 for individuals in the U.S.). IRS Publication 550 provides comprehensive information on investment income and expenses, including capital gains and losses¹⁰,⁹.

The carryforward amount is then applied to future years until it is fully utilized or expires, depending on specific tax regulations.

Interpreting the Carryforward

Interpreting a carryforward primarily involves understanding its potential to reduce future tax liability. A significant carryforward, such as a large net operating loss, indicates that a business experienced substantial losses relative to its gross income in a prior period. For financial analysts, the existence and magnitude of carryforwards are important for forecasting future tax expenses on a company's financial statements.

The value of a carryforward is directly tied to the expectation of future profitability. If a company anticipates consistent positive business income, a carryforward offers a tangible future tax benefit. Conversely, if a company is expected to remain unprofitable, the utility of a carryforward diminishes as there may be insufficient future income to offset. Investors should assess a company's ability to generate future income when evaluating the true value of its reported carryforward assets.

Hypothetical Example

Consider "InnovateTech Inc.," a new technology startup that incurred significant expenses in its first year of operation, 2024, due to heavy investment in research and development, equipment, and hiring.

Scenario:

• 2024 (Year 1):
  • Revenue: $100,000
  • Operating Expenses (including depreciation and amortization): $600,000
  • Net Operating Loss (NOL) for 2024: $100,000 - $600,000 = -$500,000

Under current U.S. tax law, InnovateTech Inc. cannot carry back this NOL to prior years as it is a new company and carrybacks were largely restricted by the TCJA (with temporary exceptions like the CARES Act, which applied to 2018-2020 losses). However, it can carry forward this $500,000 NOL indefinitely.

• 2025 (Year 2):
  • Revenue: $800,000
  • Operating Expenses: $300,000
  • Pre-NOL Taxable Income: $800,000 - $300,000 = $500,000

InnovateTech Inc. can use its $500,000 NOL carryforward from 2024 to offset its 2025 taxable income. Under the 80% limitation for NOL carryforwards, the maximum amount of the NOL it can deduct in 2025 is:

( \text{Maximum NOL Deduction} = \text{Pre-NOL Taxable Income} \times 80% = $500,000 \times 0.80 = $400,000 )

• Tax Calculation for 2025:
  • Pre-NOL Taxable Income: $500,000
  • NOL Deduction: $400,000
  • Adjusted Taxable Income: $500,000 - $400,000 = $100,000

InnovateTech Inc. would pay taxes only on the $100,000 adjusted gross income.

• NOL Carryforward to 2026:
  • Remaining NOL from 2024: $500,000 - $400,000 = $100,000

This remaining $100,000 NOL would then be carried forward to 2026, or until it is fully utilized, continuing to reduce future tax burdens.

Practical Applications

Carryforward provisions are widely applied in various aspects of financial and tax planning:

• Corporate Tax Planning: Businesses regularly use net operating loss (NOL) carryforwards to manage their tax liability. This is especially critical for startups and companies in cyclical industries that may experience losses in early years or during economic downturns. By carrying losses forward, they can offset future profits, effectively reducing their corporate income taxes.
• Investment Losses: Individual investors utilize carryforwards for capital losses that exceed their capital gains in a given year. If an investor realizes a significant loss from selling securities, they can offset current capital gains and a limited amount of ordinary income. Any remaining loss can be carried forward indefinitely to offset future capital gains and ordinary income, as detailed in IRS Publication 550,⁸.
• Tax Credits: Certain tax credits, such as foreign tax credits or research and development credits, may also have carryforward provisions if they cannot be fully utilized in the year they are generated. This prevents the loss of valuable incentives due to insufficient current tax liability.
• Financial Reporting: The presence and potential utilization of carryforwards are reflected on a company's income statement and balance sheet, typically as deferred tax assets. This provides transparency to investors and analysts about future tax benefits.
• Government Policy: Governments frequently adjust carryforward rules to stimulate economic activity or provide relief during crises. For example, the temporary changes to NOL carryforward rules under the CARES Act during the COVID-19 pandemic aimed to provide immediate financial relief to businesses experiencing losses⁷,⁶. These policy shifts highlight the role of carryforward in broader fiscal strategies⁵.

Limitations and Criticisms

While carryforward provisions offer significant tax benefits, they are not without limitations and criticisms.

One major limitation is the time constraint some jurisdictions impose on carryforwards. Although the U.S. generally allows net operating losses (NOLs) to be carried forward indefinitely since the TCJA, prior to that, there was a 20-year limit. Other countries or specific types of losses may still have expiration dates, meaning if future profits are not generated within that timeframe, the carryforward benefit is lost.

Another significant restriction is the income limitation on the amount of taxable income that can be offset by a carryforward in any given year. For U.S. federal tax purposes, NOL carryforwards generated after 2017 are generally limited to 80% of taxable income in the year they are used⁴. This means a company cannot use a carryforward to reduce its tax liability to zero, regardless of the size of the loss. This 80% limitation can be a drawback for companies with large NOLs, as it extends the period over which they can fully realize the tax benefit.

From a critical perspective, carryforward rules can be seen as favoring established businesses over new ones. Older firms may benefit more from carryback provisions (when allowed) as they have past profits to offset, whereas newer firms often only have the option of carryforward due to a lack of prior profitable years³. Furthermore, complex rules surrounding carryforwards can add administrative burden and require expert tax accounting knowledge for proper application. Critics also argue that overly generous carryforward rules could inadvertently incentivize less efficient businesses to continue operating, as they are shielded from the full tax impact of their losses.

Carryforward vs. Carryback

The terms "carryforward" and "carryback" both refer to mechanisms for applying losses or unused tax benefits across different accounting periods for tax purposes, but they differ in the direction of application.

• Carryforward allows a current year's loss, deduction, or credit to be applied to future tax years to reduce future taxable income or tax liability. This is beneficial when a taxpayer anticipates future profits against which the current loss can be offset. In the U.S., since the Tax Cuts and Jobs Act of 2017, net operating losses (NOLs) are generally carried forward indefinitely, subject to an 80% taxable income limitation².
• Carryback allows a current year's loss to be applied to past tax years, enabling the taxpayer to amend prior tax returns and potentially receive a refund of taxes previously paid. This provides immediate cash flow relief. Prior to the TCJA, NOLs could generally be carried back two years. While the TCJA eliminated most NOL carrybacks, the CARES Act temporarily reinstated a five-year carryback period for NOLs incurred in 2018, 2019, and 2020, offering quick relief during the pandemic¹.

The key distinction lies in the timing of the tax benefit: carryforwards offer future tax reductions, while carrybacks can result in immediate tax refunds. Taxpayers typically elect the method that provides the most advantageous financial outcome based on their specific financial situation and prevailing tax laws.

FAQs

What types of losses or deductions can be carried forward?

Common items that can be carried forward include net operating losses (NOLs), excess capital losses, and certain unused tax credits. The specific types depend on the tax laws of the relevant jurisdiction.

How long can a loss be carried forward?

In the United States, for most net operating losses incurred after 2017, they can be carried forward indefinitely. However, specific rules can vary by type of loss and jurisdiction, and legislative changes can impact these durations.

Does a carryforward guarantee a tax reduction?

A carryforward does not guarantee a tax reduction. Its benefit depends on the taxpayer generating sufficient taxable income in future years against which the carryforward can be applied. If no future income or tax liability exists, the carryforward may expire unused (if subject to a time limit) or simply remain on the books.

Is carryforward only for businesses, or can individuals use it?

Both businesses and individuals can utilize carryforward provisions. For individuals, the most common use is for excess capital losses that exceed annual deduction limits against ordinary income. Businesses primarily use it for net operating losses.