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Tax carryforward

What Is Tax Carryforward?

Tax carryforward is an accounting and tax provision that allows a taxpayer, whether an individual or a business, to apply a current year's net operating loss (NOL) to offset taxable income in future tax periods. This provision falls under the broader category of tax planning, offering a crucial mechanism for businesses and individuals to mitigate the financial impact of unprofitable years. When a taxpayer's allowable deductions exceed their gross income for a given tax year, they incur an NOL. Instead of simply losing the benefit of these excess deductions, the tax carryforward mechanism enables them to be "carried forward" and used to reduce future tax liabilities.

History and Origin

The concept of allowing businesses to carry forward or carry back losses has been a feature of the U.S. tax code for many decades, evolving through various legislative changes aimed at balancing tax revenue with economic stability and business continuity. Historically, net operating losses could be carried back to offset past profits, resulting in tax refunds, and carried forward for a limited number of years.

Significant changes to the rules governing tax carryforwards and carrybacks were introduced with the Tax Cuts and Jobs Act (TCJA) of 2017. Before the TCJA, NOLs could generally be carried back two years and forward up to 20 years, with no limitation on the percentage of taxable income they could offset. The TCJA largely eliminated NOL carrybacks for most taxpayers and limited the NOL deduction to 80% of taxable income for tax years beginning after 2017, while allowing for an indefinite carryforward period.4

In response to the economic disruption caused by the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 temporarily allowed NOLs from 2018, 2019, and 2020 to be carried back for up to five years. It also temporarily suspended the 80% taxable income limitation for tax years beginning before 2021. However, current rules largely revert to the modified TCJA provisions: NOLs arising in tax years ending after 2020 can generally only be carried forward indefinitely, and the deduction is capped at 80% of taxable income, with exceptions for certain farming losses.3

Key Takeaways

  • Tax carryforward permits taxpayers to use current-year net operating losses (NOLs) to reduce future taxable income.
  • It provides a crucial mechanism for businesses and individuals to offset tax liabilities in more profitable years following a loss.
  • Under current U.S. federal law, most NOLs can be carried forward indefinitely.
  • The deduction for NOLs carried forward is generally limited to 80% of taxable income in the year they are used.
  • Tax carryforwards are recorded as deferred tax assets on a company's financial statements.

How Tax Carryforwards Are Calculated and Applied

The calculation of a net operating loss (NOL) involves several adjustments to a taxpayer's negative taxable income. Not all deductions are allowed when figuring an NOL. For individuals, estates, and trusts, the IRS provides specific guidance on how to determine the amount of an NOL, which often differs from the negative taxable income shown on a tax return. Certain nonbusiness deductions, capital losses in excess of capital gains, and the NOL deduction itself are generally not allowed when computing the actual NOL.2

Once the NOL is determined, the tax carryforward rules dictate how it can be applied in subsequent years. For tax years beginning after December 31, 2020, an NOL can generally be carried forward indefinitely. The deduction for these carried-forward losses is limited to 80% of the taxpayer's taxable income, calculated without regard to the NOL deduction. This means that even with a large NOL carryforward, a taxpayer will still owe tax on at least 20% of their taxable income in a profitable year.

Interpreting the Tax Carryforward

The presence and size of a tax carryforward indicate that a business or individual has experienced a period where their deductible expenses significantly outweighed their income. From a business perspective, a substantial tax carryforward can reflect early-stage losses for a new venture (common for startup expenses) or a downturn in profitability due to economic conditions, industry-specific challenges, or operational issues.

For investors and analysts, understanding a company's tax carryforward balance is important. It represents a future tax benefit—a reduction in future tax obligations. This can impact a company's cash flow and reported earnings in profitable years. The deferred tax asset recognized on the balance sheet due to an NOL carryforward reflects this anticipated future tax savings, subject to realization based on future profitability and accounting principles.

Hypothetical Example

Consider "InnovateTech Inc.," a new software development company. In its first year of operation, 2024, InnovateTech incurs significant research and development costs, marketing expenses, and salaries, resulting in a net operating loss (NOL) of $500,000.

Under current tax carryforward rules, InnovateTech cannot carry this loss back to previous years. Instead, it must carry the $500,000 NOL forward to offset future taxable income.

In 2025, InnovateTech releases a popular new product and achieves a taxable income of $300,000 before considering the NOL carryforward. Due to the 80% limitation, InnovateTech can only use a portion of its NOL in 2025.

The deductible NOL for 2025 is calculated as:

Deductible NOL=Taxable Income×80%Deductible NOL=$300,000×0.80=$240,000\text{Deductible NOL} = \text{Taxable Income} \times 80\% \\ \text{Deductible NOL} = \$300,000 \times 0.80 = \$240,000

InnovateTech's taxable income for 2025, after applying the NOL deduction, would be:

Adjusted Taxable Income=Taxable Income−Deductible NOLAdjusted Taxable Income=$300,000−$240,000=$60,000\text{Adjusted Taxable Income} = \text{Taxable Income} - \text{Deductible NOL} \\ \text{Adjusted Taxable Income} = \$300,000 - \$240,000 = \$60,000

InnovateTech would owe taxes on $60,000 of income in 2025. The remaining NOL balance to carry forward to 2026 would be:

Remaining NOL=Initial NOL−Deductible NOLRemaining NOL=$500,000−$240,000=$260,000\text{Remaining NOL} = \text{Initial NOL} - \text{Deductible NOL} \\ \text{Remaining NOL} = \$500,000 - \$240,000 = \$260,000

This remaining $260,000 NOL can be carried forward indefinitely until fully utilized, subject to the 80% limitation in each future year.

Practical Applications

Tax carryforwards are a fundamental component of financial and tax planning for businesses and individuals experiencing losses. They are particularly relevant for:

  • New Businesses and Startups: Many new businesses incur losses in their initial years due to high startup expenses, research and development, and slow revenue growth. Tax carryforwards allow these businesses to defer tax benefits until they become profitable.
  • Cyclical Industries: Companies in cyclical industries, such as manufacturing or resource extraction, often experience significant fluctuations in profitability. Carryforward provisions help smooth out their tax burden over time, taxing them on average profitability rather than year-to-year extremes.
    *1 Companies Undergoing Restructuring: Businesses that undergo significant restructuring, divestitures, or experience large one-time losses can utilize tax carryforwards to manage their tax liabilities in subsequent recovery periods.
  • Individuals with Business Losses: Individuals who operate sole proprietorships, partnerships, or S corporations can pass through business losses to their personal tax returns, which may result in an individual NOL eligible for carryforward. Guidance for individuals can be found in IRS Publication 536.

Limitations and Criticisms

While beneficial, tax carryforwards have certain limitations and can face criticism:

  • 80% Taxable Income Limitation: For most NOLs generated after 2017 (with exceptions for 2018-2020 under CARES Act), the deduction is capped at 80% of taxable income. This means a company or individual will always pay tax on at least 20% of their income, even if they have substantial NOL carryforwards, reducing the immediate benefit of the loss.
  • Valuation of Deferred Tax Assets: Companies record NOL carryforwards as deferred tax assets on their balance sheets. However, if there is uncertainty about a company's future profitability, a valuation allowance may be required against these assets, reducing their reported value. This reflects the uncertainty that the company will generate enough future taxable income to utilize the carryforward.
  • Changes in Ownership: Rules often limit the use of NOLs following certain corporate acquisitions or significant changes in ownership. These limitations prevent profitable companies from acquiring struggling ones primarily to gain access to their tax losses, a practice known as "loss trafficking."
  • Complexity and Administrative Burden: The rules surrounding NOLs and tax carryforwards can be complex, requiring careful calculation and adherence to specific IRS guidelines, as detailed in various tax publications. This complexity can be burdensome for taxpayers and require professional assistance.

Tax Carryforward vs. Tax Carryback

The primary distinction between tax carryforward and tax carryback lies in the direction in which a net operating loss (NOL) is applied. A tax carryforward allows a current year's NOL to be used to offset future taxable income. In contrast, a tax carryback permits a current year's NOL to be applied against taxable income from previous tax years, often resulting in a refund of previously paid taxes.

Historically, both carryforwards and carrybacks were common tools. However, legislative changes, notably the Tax Cuts and Jobs Act of 2017, significantly altered these rules for most taxpayers. Currently, for NOLs arising in tax years ending after 2020, tax carrybacks are largely eliminated, with specific exceptions for certain farming losses. The shift to primarily allowing only tax carryforward means businesses and individuals must focus on planning for future profitability to realize the benefits of their current losses, rather than seeking immediate refunds from past tax payments.

FAQs

Q: Can a tax carryforward expire?

A: For most net operating losses (NOLs) arising in tax years beginning after 2017 (with some exceptions for specific years), the tax carryforward can be used indefinitely and does not expire under U.S. federal tax law. Prior to this, NOLs typically had a 20-year carryforward limit.

Q: Is there a limit to how much of an NOL I can use in one year?

A: Yes, for most net operating losses arising in tax years beginning after December 31, 2020, the deduction from a tax carryforward is generally limited to 80% of your taxable income in the year the loss is used. This means you will still owe tax on at least 20% of your income.

Q: How does a tax carryforward benefit a business?

A: A tax carryforward benefits a business by allowing it to reduce its future tax liabilities during profitable years. This can improve cash flow and overall financial health, especially for companies that experience losses in their early stages or during economic downturns, by lowering the total amount of taxes paid over time. It functions similarly to certain tax credits by reducing the final tax bill.

Q: Can individuals use tax carryforwards?

A: Yes, individuals can incur a net operating loss (NOL) from business activities (such as a sole proprietorship or a share of partnership/S-corporation losses) that can result in an individual NOL. This individual NOL can then be carried forward to offset future taxable income on their personal tax return, subject to the same rules and limitations as corporate NOLs.