Holdovers

Holdovers (Net Operating Losses): Definition, Formula, Example, and FAQs

What Is Holdovers (Net Operating Losses)?

"Holdovers," in financial terminology, primarily refers to Net Operating Losses (NOLs). A Net Operating Loss occurs when a company's or individual's allowable deductions exceed its taxable income for a given tax period. Instead of simply disappearing, these losses can often be "held over" or carried forward to offset future taxable income, thereby reducing future tax liabilities. This mechanism is a critical component of taxation and financial accounting, allowing businesses and individuals to smooth out their taxable income over time, particularly in years of low profitability or significant initial investment.

History and Origin

The concept of carrying forward losses to offset future gains has long been a feature of tax codes in many countries, designed to mitigate the inherent unfairness of taxing income on a strict annual basis when business cycles are dynamic. Without a mechanism like Net Operating Losses, a business that experiences a loss in one year and a profit in the next would be taxed heavily on its profit while its prior loss would offer no tax benefit. This system effectively averages a taxpayer's income and losses over multiple years.

In the United States, rules governing NOLs have undergone significant changes through various tax reforms. Historically, NOLs could generally be carried back to previous tax years and carried forward for a limited period. A major shift occurred with the Tax Cuts and Jobs Act (TCJA) of 2017, which largely eliminated NOL carrybacks for most taxpayers and introduced an indefinite carryforward period, alongside a limitation that NOL deductions could only offset up to 80% of taxable income in any given year.⁹ This legislative change aimed to broaden the tax base. However, the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 temporarily relaxed some of these provisions in response to the economic impact of the pandemic, allowing a five-year carryback for NOLs arising in tax years 2018, 2019, and 2020, and suspending the 80% limitation for tax years before 2021.⁸ Following the expiration of these temporary CARES Act provisions, the rules largely reverted to the TCJA framework for NOLs arising in tax years after 2020, meaning indefinite carryforwards but with the 80% taxable income limitation generally reinstated. The Internal Revenue Service (IRS) provides detailed guidance on NOLs for individuals, estates, and trusts in Publication 536.⁷

Key Takeaways

• A Net Operating Loss (NOL) occurs when allowable tax deductions exceed gross income.
• NOLs can typically be "carried forward" to reduce taxable income in future years.
• The primary purpose of NOL rules is to provide tax relief for businesses and individuals with fluctuating incomes, averaging out profitability over time.
• Current U.S. federal rules generally allow NOLs to be carried forward indefinitely but often limit their deduction to 80% of future taxable income.
• NOLs are an important consideration in tax planning and are recorded as deferred tax assets on a company's balance sheet.

Formula and Calculation

The calculation of a Net Operating Loss (NOL) involves adjusting a taxpayer's gross income and deductions to arrive at a net loss that can be carried over. While the exact calculation can be complex and varies based on taxpayer type (individual, corporation, estate, trust) and specific tax laws, the fundamental principle is that total allowable expenses and deductions exceed total income.

For individuals, the calculation generally starts by determining if adjusted gross income (AGI) is negative after considering certain adjustments. For businesses, it involves comparing all ordinary and necessary business expenses against revenue. The IRS provides specific worksheets in Publication 536 to assist taxpayers in calculating their NOL.⁶

An NOL is generally determined as:

If this calculation results in a negative number, that negative amount represents the Net Operating Loss for the year. The modifications to gross income often involve disallowing certain non-business deductions or limiting capital losses.

Interpreting the Holdovers (Net Operating Losses)

The presence and size of Net Operating Losses indicate that a business or individual had a tax year where their expenditures and write-offs significantly outstripped their income. From a financial perspective, a substantial NOL can be a valuable asset. It signifies a future tax shield that can reduce subsequent tax payments.

Interpreting NOLs involves understanding their potential impact on future tax liabilities and overall financial health. For a company, a large NOL suggests a period of unprofitability, but also provides a mechanism to lower future tax burdens once profitability resumes. Investors often consider a company's NOL carryforwards as a factor in valuing its stock, as these can represent future tax savings. Effective tax planning utilizes NOLs to optimize a company's tax position over time.

Hypothetical Example

Consider a new technology startup, InnovateTech Inc., which launched in 2024. In its first year of operation, the company incurred significant research and development expenses, marketing costs, and salaries, totaling $2,000,000. Its initial revenue from early product sales was only $500,000.

To calculate its Net Operating Loss:

InnovateTech Inc. has a Net Operating Loss of $1,500,000 for 2024. According to current U.S. tax law, this NOL can be carried forward indefinitely.

In 2025, InnovateTech Inc.'s product gains traction, and it generates a taxable income of $1,000,000. Without the NOL, the company would owe taxes on this full amount. However, InnovateTech can utilize its NOL carryforward. Assuming the 80% limitation for post-2020 NOLs applies, it can use 80% of its 2025 taxable income to offset the NOL.

So, InnovateTech Inc. can deduct $800,000 of its $1,500,000 NOL in 2025.

The company will only pay taxes on $200,000 of income in 2025, saving a significant amount compared to if it could not use the NOL. The remaining NOL balance of $700,000 ($1,500,000 - $800,000) can continue to be carried forward to future years, as reflected on its income statement and financial filings.

Practical Applications

Net Operating Losses are a fundamental aspect of corporate finance and individual tax strategy.

• Tax Optimization: Companies utilize NOLs to minimize current and future tax burdens. By applying these "holdovers" against future profits, they effectively reduce their tax base, leading to lower tax payments. This is a key element of strategic tax planning.
• Financial Reporting: For publicly traded companies, NOLs are reported on the balance sheet as deferred tax assets. This acknowledges that the company has a future tax benefit due to past losses, impacting its overall financial position and valuation.
• Mergers and Acquisitions: NOL carryforwards can be a valuable asset in mergers and acquisitions. An acquiring company might consider the target company's NOLs as a potential future tax shield, though limitations exist on the usability of NOLs after a change in ownership to prevent "NOL trafficking."
• Economic Stabilization: At a macroeconomic level, NOL provisions act as an automatic stabilizer, providing relief to businesses during economic downturns and encouraging investment by reducing the downside risk associated with initial losses. The Congressional Research Service has published analyses on the economic effects of such provisions, including those from the TCJA.⁵

Limitations and Criticisms

While advantageous, Net Operating Loss rules come with limitations and have faced criticism.

• 80% Taxable Income Limitation: A significant limitation for NOLs arising in tax years after 2017 (with the exception of the temporary CARES Act suspension for specific years) is that they can generally only offset 80% of a taxpayer's taxable income in the carryforward year. This means a company or individual will still owe some tax, even if they have substantial NOLs. This provision was part of broader tax reform aimed at increasing government revenue.⁴
• Ownership Changes: Internal Revenue Code (IRC) Section 382 imposes strict limitations on the use of NOLs following certain ownership changes in a corporation. If a significant ownership change occurs (e.g., more than 50% change in stock ownership over a three-year period), the amount of pre-change NOLs that can be used annually in future years is generally limited. This is designed to prevent profitable companies from acquiring struggling companies primarily for their NOLs, a practice known as "NOL trafficking."
• Complexity: The rules surrounding NOLs, particularly with various legislative changes and specific adjustments for different types of taxpayers or losses (e.g., farming losses), can be highly complex. This complexity often requires specialized tax accounting expertise, increasing compliance costs for businesses.
• No Tax Credit Offset: NOLs reduce taxable income, but they do not directly offset tax credits. Tax credits reduce tax liability dollar-for-dollar, while NOLs reduce the base upon which taxes are calculated.

Holdovers (Net Operating Losses) vs. Net Operating Loss Carryback

The term "Holdovers" fundamentally refers to the carryforward aspect of Net Operating Losses. While both Net Operating Loss carryback and carryforward deal with applying current losses to other tax periods, they differ significantly in their direction and current applicability under U.S. federal tax law.

• Net Operating Loss (NOL) Carryforward: This is the current prevailing method for utilizing NOLs for most taxpayers. It allows a business or individual to take a loss incurred in the current tax year and apply it to reduce taxable income in future tax years. For most NOLs arising after 2020, they can be carried forward indefinitely, subject to an 80% taxable income limitation.
• Net Operating Loss (NOL) Carryback: This method allowed a business or individual to apply a loss from the current tax year to reduce tax liabilities in past tax years, often resulting in a tax refund. Before the TCJA of 2017, a two-year carryback was common, followed by a 20-year carryforward. The CARES Act temporarily reinstated a five-year carryback for NOLs from 2018-2020. However, for most NOLs arising after 2020, the federal carryback provision has been eliminated, with limited exceptions (e.g., certain farming losses).³

The key distinction is the direction of the loss application: carryforward looks to the future, while carryback looks to the past.

FAQs

What is the primary purpose of Net Operating Losses?

The primary purpose of Net Operating Losses is to allow taxpayers to smooth out their income over time for tax purposes. This prevents businesses from being unfairly taxed on profits in some years without accounting for losses incurred in others, providing a form of tax relief during periods of unprofitability.

How far back can a Net Operating Loss be carried?

Under current U.S. federal tax law for most taxpayers, Net Operating Losses arising in tax years beginning after 2020 generally cannot be carried back to previous tax years. They can only be carried forward indefinitely. There are specific, limited exceptions, such as for certain farming losses, which may have a two-year carryback period.²

Is there a limit to how much a Net Operating Loss can reduce future income?

Yes, for most Net Operating Losses arising in tax years beginning after 2017 (with temporary exceptions), the deduction for an NOL carried forward to a future year is generally limited to 80% of your taxable income before considering the NOL deduction itself. This means an entity will still typically owe some tax even with an NOL.

Do Net Operating Losses expire?

For most Net Operating Losses arising in U.S. federal tax years beginning after 2017, they do not expire and can be carried forward indefinitely until fully utilized. However, for NOLs from tax years ending before 2018, there was generally a 20-year carryforward limit.¹

How do Net Operating Losses affect a company's financial statements?

Net Operating Losses are recorded on a company's balance sheet as a deferred tax asset. This asset represents the future tax savings the company expects to realize by using the NOLs to reduce its tax payments in profitable future periods.