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Net operating losses

What Are Net Operating Losses?

Net operating losses (NOLs) occur when a company's allowable tax deductions exceed its taxable income for a given tax period. In essence, it signifies a negative taxable income. Within the realm of corporate finance and taxation, NOLs are a critical concept because tax authorities typically do not compensate unprofitable businesses for their losses. Instead, they allow these losses to be carried forward or, in some cases, carried back to offset taxable income in other years, thereby reducing future or past tax liabilities. This mechanism enables businesses to "smooth out" their income over time for tax purposes.

History and Origin

The concept of allowing businesses to account for losses across different tax periods has a long history in U.S. tax law. The ability to use losses to offset income earned in other years can be traced back to the Revenue Act of 1918, which first allowed for a one-year carryback and one-year carryforward of losses.20, 21 Over the decades, the specific rules governing net operating losses, including carryback and carryforward periods, have undergone various changes in response to economic conditions and policy objectives.

A significant shift occurred with the Tax Cuts and Jobs Act (TCJA) of 2017, which eliminated the ability to carry back losses for most taxpayers and introduced a limitation that NOL deductions could only offset up to 80% of taxable income. It also allowed for indefinite carryforwards.18, 19 However, in response to the economic impact of the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 temporarily suspended many of these TCJA restrictions. The CARES Act retroactively allowed for a five-year carryback period for NOLs incurred in tax years beginning in 2018, 2019, and 2020, and temporarily removed the 80% taxable income limitation for those years, allowing NOLs to offset 100% of income.15, 16, 17 These temporary changes provided much-needed liquidity to businesses facing substantial losses. After 2020, for most taxpayers, NOLs arising in tax years beginning after December 31, 2020, no longer have a carryback period (with exceptions for farming losses), and carryforwards remain indefinite but are again subject to the 80% taxable income limitation.13, 14

Key Takeaways

  • Net operating losses (NOLs) occur when a company's deductions exceed its income for a tax year, resulting in negative taxable income.
  • NOLs can be used to reduce taxable income in prior or future tax years, thereby lowering tax liabilities.
  • The rules for NOL carrybacks and carryforwards have changed historically, notably with the Tax Cuts and Jobs Act of 2017 and the CARES Act of 2020.
  • NOLs are important for financial management and tax planning, helping businesses manage income volatility.
  • An NOL can give rise to a deferred tax asset on a company's balance sheet.

Formula and Calculation

A net operating loss is generally the amount by which a taxpayer's allowable deductions for a tax year exceed their gross income for that year.12 While the basic concept is straightforward, specific adjustments are required to calculate the precise NOL amount that can be carried over. The IRS provides detailed guidelines in publications like Publication 536 for individuals, estates, and trusts.11

The basic idea can be represented as:

Net Operating Loss (NOL)=Allowable Tax DeductionsGross Income\text{Net Operating Loss (NOL)} = \text{Allowable Tax Deductions} - \text{Gross Income}

It is important to note that certain non-business deductions or losses, such as capital losses in excess of capital gains, may be limited or excluded when calculating the actual NOL for carryback or carryforward purposes.10 Therefore, the negative amount shown as earnings before taxes (EBT) on a company's income statement is typically not the exact amount of the NOL that can be utilized for tax purposes.

Interpreting Net Operating Losses

Net operating losses are a significant indicator of a business's financial health, particularly its profitability. A substantial NOL often indicates a period of significant investment, startup costs, or, conversely, operational difficulties and financial distress. From a tax perspective, the presence of NOLs represents a valuable future tax shield. Companies with large NOLs may not pay corporate tax for several years, depending on the magnitude of the NOL and their future taxable income.

The interpretation of an NOL also depends on the context. For a rapidly growing startup, initial NOLs are often expected as they incur heavy research and development expenses or marketing costs to establish market share. For mature companies, large, unexpected NOLs could signal a downturn or significant restructuring. Understanding how a company intends to utilize its NOLs (e.g., against past profits for a refund, or against future profits) is crucial for assessing its financial strategy and outlook.

Hypothetical Example

Consider "InnovateTech Solutions," a new software development company. In its first year of operation (Year 1), InnovateTech invests heavily in research and development, marketing, and hiring skilled personnel.

  • Year 1:
    • Revenue: $500,000
    • Operating Expenses (including R&D, salaries, marketing): $1,200,000
    • Allowable Tax Deductions: $1,200,000
    • Taxable Income: $500,000 - $1,200,000 = -$700,000

InnovateTech has an NOL of $700,000 for Year 1. Since losses after 2020 generally cannot be carried back (with exceptions), InnovateTech must carry this NOL forward.

  • Year 2:
    • Revenue: $1,500,000
    • Operating Expenses: $800,000
    • Taxable Income before NOL deduction: $1,500,000 - $800,000 = $700,000

Assuming a 21% corporate tax rate and applying the 80% NOL deduction limit (for losses arising after 2020), InnovateTech can offset $700,000 * 80% = $560,000 of its Year 2 taxable income with its Year 1 NOL.

  • Year 2 Taxable Income after NOL deduction: $700,000 - $560,000 = $140,000
  • Year 2 Tax Liability: $140,000 * 21% = $29,400
  • Remaining NOL to carry forward: $700,000 (original NOL) - $560,000 (NOL used) = $140,000

Without the NOL, InnovateTech would have paid taxes on the full $700,000 of taxable income in Year 2. The NOL significantly reduced its tax burden, providing valuable cash flow.

Practical Applications

Net operating losses have several important practical applications across various financial disciplines:

  • Tax Planning and Financial Management: Businesses strategically utilize NOLs to minimize their tax liabilities in profitable years. This can involve carrying losses forward to offset future income or, when permitted, carrying them back to claim refunds for taxes paid in previous profitable years. This "smoothing" effect allows companies to manage cash flow more effectively and reduces the overall tax burden over the business cycle.
  • Valuation and Mergers and Acquisitions: Companies with significant NOL carryforwards can be more attractive acquisition targets. The acquiring company may be able to utilize the target's NOLs to offset its own future taxable income, creating a tax synergy. However, strict IRS rules, such as Section 382 of the Internal Revenue Code, often limit the amount of NOLs that can be used following a change in ownership to prevent tax avoidance schemes.
  • Economic Stabilization: From a macroeconomic perspective, allowing NOL carrybacks can act as an automatic stabilizer during economic downturns. Businesses that incur losses can obtain tax refunds from prior profitable years, providing immediate liquidity that can help them survive and retain employees during difficult times.8, 9 This policy helps foster economic efficiency by mitigating the impact of income volatility.
  • Accounting and Reporting: NOLs are recognized on a company's balance sheet as a deferred tax asset. This asset represents the future tax savings expected to be realized when the NOLs are applied against future taxable income. The calculation and recognition of deferred tax assets derived from NOLs are crucial aspects of financial reporting.

Limitations and Criticisms

Despite their benefits, net operating losses and the rules governing them have limitations and have faced criticism:

  • Complexity: The rules surrounding NOLs, particularly with various legislative changes like the TCJA and the CARES Act, can be highly complex. This complexity can make it challenging for businesses to accurately calculate and utilize their NOLs, potentially requiring extensive professional tax assistance. The IRS provides detailed publications, such as Publication 536, to guide taxpayers, but understanding all nuances can be difficult.7
  • 80% Limitation: For NOLs arising after 2017 (and after the temporary CARES Act suspension for 2018-2020 losses), the general rule limiting their deduction to 80% of taxable income can extend the period over which a company can fully utilize its losses. This means even if a company becomes highly profitable, it may still pay some tax if its NOLs are substantial.6
  • Liquidity vs. Carryforward: The elimination of carrybacks (for most NOLs arising after 2020) means companies experiencing current losses cannot immediately claim refunds from past profitable years. This can restrict immediate liquidity, especially for new businesses or those facing unexpected downturns. While indefinite carryforwards offer long-term benefits, they do not provide the same immediate cash injection that carrybacks offer.5
  • Tax Avoidance Concerns: Historically, the ability to utilize NOLs has raised concerns about potential tax avoidance strategies, particularly in the context of mergers and acquisitions. Regulators implement rules, such as Section 382, to limit the use of acquired NOLs to prevent companies from purchasing distressed businesses solely for their tax benefits.4
  • Uncertainty of Future Profitability: The value of an NOL carryforward is contingent upon a company generating sufficient future taxable income to utilize the loss. If a company continues to incur losses or ceases operations, the NOLs may expire unused, diminishing their value.

Net Operating Losses vs. Deferred Tax Assets

While closely related, net operating losses and deferred tax assets are distinct concepts in accounting and taxation.

FeatureNet Operating Losses (NOLs)Deferred Tax Assets (DTAs)
DefinitionThe excess of a company's tax deductions over its taxable income for a given period. It's a tax concept reflecting a loss for tax purposes.A balance sheet account representing future tax savings. It arises when a company has paid more taxes than it actually owes (temporary difference) or has deductible items (like NOLs) that will reduce future tax payments.
OriginGenerated when a company incurs a loss for tax purposes.Arise from temporary differences between financial accounting (GAAP) and tax accounting, or from tax loss carryforwards (NOLs) and tax credits.
NatureA tax attribute that can be "carried" to other tax periods.An asset recognized on the balance sheet, representing a future economic benefit.
MeasurementThe amount of the tax loss itself.The tax effect of the temporary difference or NOL. It is calculated by multiplying the NOL amount by the applicable future tax rate.
Financial StatementNot directly listed as a line item, but impacts calculations of taxable income and thus tax expense on the income statement and cash taxes paid (on the cash flow statement).Appears on the asset side of the balance sheet.

Essentially, an NOL is the underlying tax loss itself, while a deferred tax asset is the accounting recognition of the future tax benefit derived from that NOL.

FAQs

What happens to a net operating loss if a company never becomes profitable again?

If a company with a net operating loss (NOL) never generates sufficient taxable income to utilize the NOL carryforwards, the NOLs may eventually expire unused. While many jurisdictions now allow indefinite carryforwards for recent NOLs, some older NOLs might have had expiration dates. If a company liquidates or goes out of business without using its NOLs, the benefit is lost.

Can individuals incur net operating losses?

Yes, individuals, estates, and trusts can incur net operating losses (NOLs) primarily from business or farming activities.3 Similar to corporations, these losses can be carried forward to offset future taxable income. The Internal Revenue Service (IRS) provides specific guidelines in Publication 536 for calculating and utilizing individual NOLs, which involve adjusting adjusted gross income and certain non-business deductions.2

Do all types of losses qualify as net operating losses?

No, not all losses qualify as net operating losses (NOLs). An NOL typically arises from trade or business activities. Personal losses, such as gambling losses, or certain investment losses that are not part of a trade or business, generally do not contribute to an NOL that can be carried back or forward. Specific rules apply regarding capital losses and non-business deductions when calculating an NOL.1