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Operating loss carryforwards

What Is Operating Loss Carryforwards?

Operating loss carryforwards are a tax accounting provision that allows a company or individual to use a net operating loss (NOL) incurred in one tax period to offset taxable income in future tax periods. This mechanism, part of broader corporate tax regulations, aims to smooth out the impact of fluctuating business cycles on taxation. When a business's allowable deductions exceed its gross income for a given tax year, it results in an NOL. Instead of losing the tax benefit of these excess deductions, the business can "carry forward" this loss, reducing its future tax liability. This provision can significantly impact a company's cash flow and overall financial health, particularly for businesses in volatile industries or those undergoing significant investment.

History and Origin

The concept of allowing businesses to utilize losses against future profits has been a long-standing feature of tax codes in many countries, including the United States. Such provisions acknowledge that business profitability often fluctuates, and a single year's loss should not permanently disadvantage a taxpayer who otherwise operates profitably over time.

In the U.S., the rules governing net operating losses and their carryforwards have undergone several significant changes. Prior to 2018, U.S. federal tax law generally allowed businesses to carry back an NOL for two years and carry it forward for up to 20 years. The Tax Cuts and Jobs Act (TCJA) of 2017 significantly altered these rules, prohibiting NOL carrybacks for most taxpayers and limiting NOL deductions to 80% of taxable income for tax years beginning after December 31, 2017. However, the TCJA also removed the 20-year limitation, allowing for an indefinite carryforward period.12, 13

The economic disruption caused by the COVID-19 pandemic led to temporary changes in these rules. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted in March 2020, temporarily reinstated a five-year carryback period for NOLs arising in tax years beginning in 2018, 2019, and 2020. This act also temporarily suspended the 80% taxable income limitation for NOLs carried to tax years beginning before 2021, allowing businesses to fully offset prior years' income.10, 11 These changes were designed to provide immediate liquidity to businesses facing an economic downturn and help them manage through the crisis.9 For individuals, estates, and trusts, detailed guidance on calculating and utilizing net operating losses is provided by the Internal Revenue Service (IRS) in Publication 536.8

Key Takeaways

  • Operating loss carryforwards allow businesses to use current losses to reduce future tax liabilities.
  • This provision provides tax relief and helps stabilize businesses with fluctuating profitability.
  • U.S. tax laws on NOL carryforwards have changed notably with the Tax Cuts and Jobs Act (TCJA) and the CARES Act.
  • Under current U.S. federal law, most operating losses can be carried forward indefinitely but are generally limited to offsetting 80% of future taxable income.
  • Understanding and managing operating loss carryforwards is crucial for effective tax planning and financial reporting.

Formula and Calculation

While there isn't a single universal "formula" for operating loss carryforwards, the process involves calculating the initial net operating loss (NOL) and then determining how it applies to future taxable income.

The fundamental concept is:

[
\text{NOL} = \text{Total Deductions} - \text{Total Gross Income}
]

If the result is positive, it represents the NOL. This NOL amount can then be carried forward.

For tax years beginning after December 31, 2020, in the United States, the net operating loss deduction for any tax year generally cannot exceed the lesser of:

  1. The aggregate amount of net operating loss carryovers to the given year.
  2. 80% of the taxable income computed without regard to any NOL deduction.7

For example, if a company has a $1,000,000 NOL to carry forward and future taxable income of $700,000, the maximum NOL deduction it can claim would be 80% of $700,000, which is $560,000. The remaining NOL of $440,000 ($1,000,000 - $560,000) would then be carried forward to subsequent years.

Interpreting the Operating Loss Carryforwards

Operating loss carryforwards are a significant item for a company's financial analysis. A substantial operating loss carryforward balance suggests that the company has experienced significant losses in prior periods. From an investor's perspective, this can be a double-edged sword. On one hand, large operating loss carryforwards indicate past financial struggles. On the other hand, they represent a valuable asset, as they can reduce future tax payments, effectively boosting future earnings per share when the company returns to profitability.

Analysts often look at the magnitude of a company's net operating loss carryforwards and the likelihood of the company generating sufficient future profits to utilize them. These carryforwards are typically recorded as a deferred tax asset on the company's balance sheet and are subject to valuation allowances if their future realization is not considered probable. The presence of significant carryforwards can also influence a company's attractiveness in mergers and acquisitions, as the acquiring company might benefit from using the target company's losses to offset its own future taxable income.

Hypothetical Example

Imagine "TechStart Inc.," a newly founded software company.

  • Year 1: TechStart Inc. invests heavily in research and development and marketing, leading to significant expenses. Its total deductions (including operating expenses, depreciation, etc.) amount to $2,000,000, while its revenue is only $500,000.

    • NOL Calculation: $2,000,000 (Deductions) - $500,000 (Revenue) = $1,500,000 Net Operating Loss.
    • TechStart Inc. now has an operating loss carryforward of $1,500,000.
  • Year 2: TechStart Inc.'s software gains traction, and its revenue grows significantly. It generates a taxable income of $600,000 before considering the NOL carryforward.

    • Under current U.S. federal tax law, TechStart Inc. can generally deduct up to 80% of its taxable income using its NOL carryforward.
    • Allowable NOL Deduction: 80% of $600,000 = $480,000.
    • Taxable Income After NOL: $600,000 - $480,000 = $120,000.
    • TechStart Inc. will pay corporate tax only on $120,000 of income in Year 2.
    • Remaining NOL Carryforward: $1,500,000 (Initial NOL) - $480,000 (Used in Year 2) = $1,020,000.

TechStart Inc. will continue to carry forward the remaining $1,020,000 NOL to future years, subject to the 80% limitation, until the loss is fully utilized or expires (though for post-2017 losses, the carryforward period is indefinite).

Practical Applications

Operating loss carryforwards appear in several key areas of finance and business:

  • Corporate Taxation: Companies with a history of losses can significantly reduce their future corporate tax burden. This is especially relevant for startups, businesses in cyclical industries, or those undergoing major restructuring.
  • Financial Reporting: Operating loss carryforwards lead to the recognition of deferred tax assets on a company's financial statements, specifically on the balance sheet. Proper accounting for these assets is critical for accurate financial reporting and compliance with accounting standards.
  • Mergers and Acquisitions (M&A): The availability of substantial operating loss carryforwards can be a significant factor in M&A deals. An acquiring company may find a target company with a history of losses attractive because the acquiring entity could potentially use those carryforwards to offset its own future taxable income, thereby reducing its overall tax liability.
  • Economic Stimulus: Governments may modify NOL rules, such as extending carryback periods or suspending deduction limits, to provide economic stimulus during periods of recession or crisis. For instance, the CARES Act's temporary changes to NOL rules during the COVID-19 pandemic aimed to inject cash flow into struggling businesses.5, 6

Limitations and Criticisms

While operating loss carryforwards provide important tax relief, they also come with limitations and have faced criticism:

  • Valuation Allowance: Companies must assess the likelihood of realizing the tax benefit of their operating loss carryforwards. If it is more likely than not that some portion or all of the deferred tax asset will not be realized, a valuation allowance must be recorded, which reduces the reported value of the asset on the balance sheet.
  • 80% Limitation: The current U.S. federal limitation of 80% of taxable income means that a company can never fully eliminate its tax liability in a profitable year using only NOL carryforwards. This ensures some tax is paid, even by businesses with substantial past losses.
  • Complexity and Manipulation: The rules surrounding NOLs can be complex, especially with changes in tax legislation, leading to potential for misinterpretation or even attempts at manipulation. The broader U.S. tax system itself has been criticized for its complexity, which can make understanding and applying provisions like NOLs challenging.4
  • Change of Ownership Rules (Section 382): To prevent "trafficking" in losses (i.e., acquiring a company solely for its NOLs), Internal Revenue Code Section 382 imposes limitations on the annual utilization of NOLs following a change in ownership of a corporation. This limits the amount of pre-change losses that can be used to offset post-change income.

Operating loss carryforwards vs. Net Operating Loss

While closely related, "operating loss carryforwards" and "net operating loss" refer to distinct concepts in tax accounting.

A net operating loss (NOL) is the actual amount by which a company's allowable deductions exceed its gross income for a specific tax year. It is the result of a calculation performed at the end of a losing tax period.

Operating loss carryforwards, on the other hand, refer to the mechanism by which an NOL can be applied to future tax periods. It's the action of taking that calculated NOL from a prior year and using it to reduce taxable income in a subsequent profitable year. So, an NOL is the loss itself, while an operating loss carryforward is the tax treatment or asset created by that loss, allowing it to be applied against future income.

FAQs

What types of businesses can use operating loss carryforwards?

Most businesses, including C corporations, S corporations, partnerships, and sole proprietorships, can effectively use the concept of net operating losses, though the specific rules and limitations vary by entity type. For partnerships and S corporations, the losses generally flow through to the individual partners or shareholders, who then use them to figure their individual net operating losses.3

Is there a limit to how long an operating loss can be carried forward?

For net operating losses arising in tax years beginning after December 31, 2017, the Tax Cuts and Jobs Act (TCJA) eliminated the 20-year carryforward limit, allowing these losses to be carried forward indefinitely.2 However, they are generally limited to offsetting 80% of taxable income in any future year.

Can an operating loss be carried back to previous years?

Under current U.S. federal tax law, for net operating losses arising in tax years ending after December 31, 2020, carrybacks are generally not permitted, with some exceptions (e.g., certain farming losses).1 However, the CARES Act temporarily allowed a five-year carryback for losses incurred in 2018, 2019, and 2020 to provide economic relief during the pandemic.

How do operating loss carryforwards affect a company's financial statements?

Operating loss carryforwards are typically recognized as a deferred tax asset on a company's balance sheet. This asset represents the future tax savings the company expects to realize by using the loss carryforwards against future taxable income. A corresponding deferred tax benefit would be recognized on the income statement in the year the NOL arises, or the valuation allowance is released.