What Is Net Operating Loss?
A net operating loss (NOL) occurs when a company's or individual's allowable deductions exceed their revenue for a given tax period, resulting in negative taxable income. As a fundamental concept in tax law and corporate finance, NOLs allow taxpayers to offset income earned in other periods, effectively smoothing out the tax burden over the business cycle. This mechanism helps businesses, particularly those with fluctuating incomes, avoid being disproportionately taxed compared to those with stable earnings. The Internal Revenue Service (IRS) provides detailed guidance on calculating and utilizing net operating losses.45
History and Origin
The ability to use losses to offset income in different tax years has a long history in U.S. tax policy, tracing back to the Revenue Act of 1918. This early legislation first permitted a one-year carryback and one-year carryforward of losses. Over the decades, the specific rules governing net operating losses have evolved significantly, with carryback and carryforward periods varying.43, 44
A major legislative shift occurred with the Tax Cuts and Jobs Act (TCJA) of 2017, which fundamentally altered the treatment of NOLs. Before the TCJA, businesses could generally carry back NOLs for two years and carry them forward for up to 20 years, and these losses could fully offset taxable income.40, 41, 42 The TCJA, however, largely eliminated the ability to carry back net operating losses for most taxpayers and imposed an 80% limitation on how much taxable income NOLs could offset in a given year. While it removed the 20-year limit on carryforwards, allowing them indefinitely, these changes were intended to help defray the overall cost of the legislation.38, 39
In response to the economic disruptions caused by the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 temporarily relaxed these restrictions. The CARES Act retroactively permitted NOLs arising in tax years 2018, 2019, and 2020 to be carried back for up to five years. It also temporarily suspended the 80% taxable income limitation for these years, allowing businesses to fully offset prior years' income and generate tax refunds.33, 34, 35, 36, 37 Following these temporary provisions, for tax years ending after 2020, most taxpayers generally cannot carry back NOLs, and the 80% taxable income limitation for carryforwards has largely been reinstated.30, 31, 32
Key Takeaways
- A net operating loss (NOL) arises when a taxpayer's deductible expenses exceed their gross income for a tax year.
- NOLs allow businesses and individuals to reduce their tax liability in profitable periods by offsetting income from other years.
- The Tax Cuts and Jobs Act (2017) significantly changed NOL rules, primarily eliminating carrybacks and introducing an 80% taxable income limitation for carryforwards.
- The CARES Act (2020) temporarily reinstated carrybacks and removed the 80% limitation for certain pandemic-affected tax years (2018-2020).
- Current federal rules generally allow NOLs to be carried forward indefinitely, subject to an 80% taxable income limitation, with limited exceptions for carrybacks.
Formula and Calculation
The calculation of a net operating loss involves comparing a taxpayer's total expenses with their total income, subject to specific adjustments mandated by tax law. While the general principle is straightforward—deductions exceed gross income—certain items are typically excluded or limited when determining the NOL amount.
For individuals, estates, and trusts, the IRS outlines specific deductions and income types that are considered when figuring an NOL. Generally, this includes losses from trade or business activities, work as an employee (though often not deductible from 2018-2025 for most taxpayers), casualty and theft losses from federally declared disasters, and rental property losses. Ite29ms generally not allowed in figuring an NOL for individuals include:
- Capital losses in excess of capital gains.
- Nonbusiness deductions exceeding nonbusiness income.
- The NOL deduction itself.
- The Section 1202 exclusion of gain from qualified small business stock.
- The Section 199A deduction for qualified business income.
Fo28r corporations, an NOL is also the excess of deductions over gross income, but with different adjustments. For example, corporations generally do not include other NOL deductions or the Section 199 domestic production activities deduction when calculating an NOL.
The basic concept can be expressed as:
If this result is positive (i.e., deductions exceed revenues), an NOL exists. The specific modifications vary based on the type of taxpayer (individual, corporation, estate, or trust) and current tax law.
Interpreting the Net Operating Loss
Interpreting a net operating loss involves understanding its implications for current and future tax liabilities, as well as its signaling effect on a company's financial health. An NOL indicates that a business has experienced a period where its operational costs outweighed its income, leading to a negative taxable profit. This does not necessarily mean the business is failing; startups or companies undergoing significant expansion may intentionally incur losses in their early stages.
For tax purposes, an NOL is a valuable asset. It represents a potential future tax shield, allowing a company to reduce future tax payments or, in some cases, claim refunds for past taxes paid. This ability to "carry" the loss forward (and historically, backward) provides a crucial mechanism for tax planning and helps stabilize the financial impact of business volatility. Investors and analysts often look at a company's NOL carryforwards disclosed in its SEC filings as a potential future benefit, impacting valuation models. The25, 26, 27 size and sustainability of these losses, along with the ability to utilize them, are key considerations.
Hypothetical Example
Consider "Tech Innovate Inc.," a newly established software development company. In its first year of operation, 2024, Tech Innovate Inc. incurs substantial expenses related to research and development, hiring, and setting up its infrastructure.
- Revenue (2024): $100,000
- Operating Expenses (2024): $600,000 (including salaries, rent, software licenses, etc.)
- Other Allowable Deductions (2024): $50,000
To calculate its net operating loss:
Taxable Income (before NOL considerations) = Revenue - Operating Expenses - Other Allowable Deductions
Taxable Income = $100,000 - $600,000 - $50,000 = -$550,000
Tech Innovate Inc. has a net operating loss of $550,000 for 2024. Under current tax law, assuming this NOL arises in a tax year ending after 2020, Tech Innovate Inc. generally cannot carry this loss back to previous years to claim a refund. However, it can carry this entire $550,000 NOL forward indefinitely.
In 2025, Tech Innovate Inc. successfully launches its product and becomes profitable:
- Taxable Income (before NOL deduction, 2025): $300,000
Under current rules, Tech Innovate Inc. can use its NOL carryforward from 2024 to offset 80% of its 2025 taxable income.
Maximum NOL deduction for 2025 = 80% of $300,000 = $240,000
Tech Innovate Inc.'s taxable income after the NOL deduction for 2025 would be:
$300,000 - $240,000 = $60,000
The company would owe taxes on $60,000. The remaining NOL carryforward would be:
$550,000 (initial NOL) - $240,000 (NOL used in 2025) = $310,000
This remaining $310,000 NOL can continue to be carried forward indefinitely, available to offset 80% of taxable income in future profitable years. This demonstrates how the net operating loss mechanism allows businesses to mitigate their tax burden during periods of profitability following periods of loss.
Practical Applications
Net operating losses serve several crucial practical applications in the realms of taxation, financial analysis, and strategic business decisions. One primary application is in tax planning. Companies often experience fluctuations in profitability. NOLs enable them to "smooth" their income over time for tax purposes, preventing a situation where they pay significant taxes in profitable years while having no tax relief in loss years. This provides a more equitable and stable tax burden.
Fo22, 23, 24r new businesses or those undergoing significant investment phases, accumulating NOLs is common. These losses can be a substantial asset, reducing future tax liabilities once the company becomes profitable. This is particularly relevant in industries with long development cycles, such as biotechnology or large-scale infrastructure projects. Furthermore, the existence and magnitude of a company's NOL carryforwards are critical for financial analysts and potential acquirers. These are often disclosed on a company's Balance sheet as deferred tax assets, representing future tax savings. During mergers and acquisitions, the NOLs of an acquired company can be a valuable consideration for the acquiring entity, although their utilization can be subject to specific Internal Revenue Code limitations, such as Section 382, which limits the use of NOLs following an ownership change.
St20, 21ate tax laws also have their own complex rules for net operating losses, which can differ from federal regulations. This adds another layer of complexity and opportunity for companies operating across multiple jurisdictions. Deloitte, for instance, has developed tools to help companies navigate the complexities of state-specific NOL provisions for tax planning and compliance.
##17, 18, 19 Limitations and Criticisms
Despite their benefits, net operating losses come with certain limitations and have faced criticism, primarily concerning their impact on government revenue and potential for misuse. One significant limitation under current U.S. federal tax law is the 80% taxable income limitation for NOL carryforwards. This rule, largely reinstated after temporary suspension by the CARES Act, means that even if a company has a large NOL, it can only reduce its taxable income by a maximum of 80% using NOL deductions in any given year. Thi14, 15, 16s ensures that profitable companies always pay some level of federal income tax, even with substantial accumulated losses.
Another critical limitation pertains to changes in corporate ownership. Under Section 382 of the Internal Revenue Code, a company's ability to utilize its NOL carryforwards can be severely restricted if it undergoes an "ownership change"—typically defined as a more than 50 percentage point change in ownership by 5% shareholders over a three-year period. This rule is designed to prevent "NOL trafficking," where companies with large accumulated losses are acquired primarily for their tax benefits. Compa12, 13nies often disclose this potential limitation in their SEC filings as a risk factor.
Critics of generous NOL rules argue that they can reduce immediate tax revenues for the government, particularly during economic downturns when losses are more prevalent. Conversely, proponents emphasize their role in promoting economic efficiency and encouraging investment by reducing the disincentive of tax burdens on volatile industries. The various legislative changes over time, as documented by reports from the Congressional Research Service, reflect an ongoing debate about balancing tax fairness, economic stimulus, and revenue generation. The c10, 11omplexity of NOL rules, particularly with different state treatments, can also pose administrative burdens for businesses and tax authorities.
N9et Operating Loss vs. Tax Deduction
While a net operating loss (NOL) is a specific type of tax deduction, it is important to understand the distinction. A tax deduction is a reduction in taxable income that results from various allowable expenses or allowances, such as business expenses, mortgage interest, or charitable contributions. These deductions reduce the amount of income subject to tax in the current year.
A net operating loss, on the other hand, is not merely a single deduction but rather the result of total allowable deductions exceeding gross income in a particular tax year. When this occurs, the "excess" of deductions over income creates the NOL. This NOL then becomes a special form of deduction that can be carried to other tax years—either forward to offset future income or, historically, backward to offset past income—to reduce tax liability in those periods. The key difference is that a regular tax deduction applies against current year income, whereas an NOL is an aggregate loss from one year that can be applied to income in other years. This unique characteristic allows for income smoothing over multiple accounting periods, as reflected in a company's income statement and impacts its overall cash flow statement.
FAQs
How long can a net operating loss be carried forward?
For tax years ending after 2017, federal tax law generally allows net operating losses to be carried forward indefinitely, meaning there is no time limit on when they must be used. However, 8they are subject to an 80% taxable income limitation for tax years beginning after December 31, 2020.
Can 7an NOL be carried back to previous tax years?
Generally, for tax years ending after 2020, net operating losses cannot be carried back to previous years. The exception is for certain farming losses, which may be carried back for two years. This is a5, 6 change from pre-2018 rules and temporary provisions of the CARES Act.
What is the 80% limitation on NOLs?
The 80% limitation means that for tax years beginning after December 31, 2020, the amount of taxable income that can be offset by net operating loss carryforwards from tax years beginning after 2017 is limited to 80% of the taxpayer's taxable income (calculated before the NOL deduction). This ensu3, 4res a portion of income remains taxable.
How does an NOL affect a company's financial statements?
A net operating loss itself is primarily a tax concept. However, its impact is reflected in a company's financial statements through deferred tax assets. When a company incurs an NOL, it creates a future tax benefit, which is recognized on the balance sheet as a deferred tax asset. The realization of this asset depends on the company generating sufficient future taxable income.
What is the purpose of allowing net operating losses?
The primary purpose of allowing net operating losses is to mitigate the inequity that would arise from taxing businesses based on annual accounting periods, especially for those with fluctuating incomes. By permitting the use of losses to offset income in other years, NOLs help to average a taxpayer's income and provide tax relief, thereby promoting investment and economic stability.1, 2