Tax loss carryforward

What Is Tax Loss Carryforward?

Tax loss carryforward is an accounting and tax provision that allows individuals and businesses to utilize current-year losses to offset future taxable income. This concept falls under the broader financial category of taxation, offering a mechanism for taxpayers to mitigate their tax liability over time. When a taxpayer's allowable deductions exceed their gross income in a given year, they incur a net operating loss (NOL) or a capital loss. Rather than simply losing the benefit of this loss, the tax loss carryforward rule permits its application against income in subsequent tax periods, reducing future tax burdens. This provision is a fundamental component of financial planning and a strategic tool for managing tax obligations.

History and Origin

The concept of offsetting current losses against future profits has been a part of tax codes in various forms for many decades, designed to smooth out the impact of cyclical business operations and unforeseen economic downturns. In the United States, net operating loss (NOL) rules have undergone several revisions through legislative acts. A significant shift occurred with the Tax Cuts and Jobs Act (TCJA) of 2017, which notably altered how NOLs could be utilized. Prior to TCJA, most businesses could carry back NOLs for two years and carry them forward for 20 years. The TCJA eliminated the carryback provision for most losses incurred after 2017 and limited the deduction of future NOLs to 80% of taxable income. However, it also allowed these losses to be carried forward indefinitely⁷. Subsequent legislation, such as the CARES Act in 2020, temporarily reintroduced a five-year carryback period for losses incurred in 2018, 2019, and 2020, and temporarily suspended the 80% limitation, before reverting to a modified version of the TCJA rules. Detailed guidance on net operating losses for individuals, estates, and trusts is provided by the Internal Revenue Service (IRS) in its Publication 536⁶.

Key Takeaways

• Tax loss carryforward allows taxpayers to use losses from one year to reduce taxable income in future years.
• This provision applies to both net operating losses from businesses and capital losses from investments.
• For losses generated after 2017, the tax loss carryforward can generally be used indefinitely, but it is typically limited to offsetting 80% of future taxable income in any given year.
• It is a crucial tax strategy for businesses and individuals experiencing significant financial downturns.

Formula and Calculation

While there isn't a single, universal "formula" for tax loss carryforward, its application involves specific rules, particularly concerning the amount that can be deducted annually and the order in which multiple carryforwards are used.

For net operating losses generated in tax years beginning after December 31, 2017, the deduction is generally limited to 80% of taxable income (computed without regard to the NOL deduction itself). Any unused portion of the NOL can be carried forward indefinitely.

For individual investors, when capital losses exceed capital gains in a given year, up to $3,000 of the excess loss can be used to offset ordinary income. Any remaining capital loss can then be carried forward indefinitely to offset future capital gains or up to $3,000 of ordinary income each year⁵.

Interpreting the Tax Loss Carryforward

The primary interpretation of a tax loss carryforward is its value as a deferred tax asset. It signifies a future tax savings opportunity, as it can reduce the amount of income subject to taxation in subsequent profitable years. For a business, a large net operating loss carryforward indicates prior years of unprofitability but also represents a valuable asset that can shield future revenue from tax. For an individual, capital loss carryforwards resulting from investment activities mean that past portfolio underperformance can provide ongoing tax relief, potentially for many years. Effective financial planning considers the presence and potential utilization of these carryforwards to optimize overall tax efficiency.

Hypothetical Example

Consider XYZ Corp., a startup business.
In Year 1, XYZ Corp. incurs a net operating loss (NOL) of $500,000 due to significant initial investments and low revenue.
In Year 2, the company becomes profitable and generates $400,000 in taxable income.

Under current rules for losses incurred after 2017, XYZ Corp. can use its tax loss carryforward to offset up to 80% of its Year 2 taxable income.
Maximum NOL deduction = $400,000 (Taxable Income) × 80% = $320,000.
Taxable income after NOL deduction = $400,000 - $320,000 = $80,000.
Remaining NOL carryforward to Year 3 and beyond = $500,000 - $320,000 = $180,000.

In this scenario, XYZ Corp. significantly reduces its current-year tax bill by utilizing the tax loss carryforward and retains a substantial portion of the loss to apply against future profits.

Practical Applications

Tax loss carryforward provisions are critical in several areas of finance:

• Corporate Finance: Companies, particularly startups or those in cyclical industries, frequently incur net operating losses in their early stages or during downturns. These carryforwards act as a future tax shield, making them more attractive to investors and enabling greater reinvestment of future profits. Publicly traded companies often disclose their NOL carryforwards in their SEC filings, as they represent a valuable asset that impacts future earnings and valuation. For example, a company's Form 10-K may include a discussion of its ability to utilize net operating loss carryforwards, noting potential limitations if an ownership change occurs.⁴
• Individual Investing: Investors can employ tax-loss harvesting strategies to intentionally realize capital losses within their portfolio. If these losses exceed capital gains and the $3,000 annual limit for offsetting ordinary income, the excess becomes a capital loss carryforward. This enables individuals to reduce future tax liabilities on capital gains or a portion of their adjusted gross income for years to come.³
• Mergers and Acquisitions (M&A): The availability of a target company's net operating loss carryforwards can be a significant factor in M&A deals, as the acquiring company may be able to use these losses to offset its own future taxable income. However, specific Internal Revenue Code (IRC) sections, such as Section 382, impose strict limitations on the use of NOLs following an ownership change to prevent the sale of loss companies primarily for their tax attributes.

Limitations and Criticisms

While beneficial, tax loss carryforward provisions have limitations:

• 80% Limitation: For most net operating losses generated after 2017, only 80% of taxable income can be offset in any given year. This means profitable entities will still pay tax on at least 20% of their income, even if they have substantial carryforwards, which can create cash flow challenges for businesses anticipating full offset.²
• Ownership Changes (Section 382): For corporations, if a significant change in ownership occurs (generally more than 50% shift in ownership by 5% shareholders over a three-year period), the annual amount of pre-change NOLs that can be used is severely limited. This limitation aims to prevent companies from being acquired solely for their tax loss attributes.
• Valuation Uncertainty: The future value of a tax loss carryforward depends on future profitability and tax rates, which are inherently uncertain. A company might never generate enough income to fully utilize its accumulated losses.
• Complexity: The rules governing tax loss carryforwards can be highly complex, requiring careful calculation and adherence to specific IRS guidelines, as outlined in publications like IRS Publication 536.¹ Misinterpretation can lead to disallowed deductions or penalties.

Tax Loss Carryforward vs. Tax Credit

Tax loss carryforward and a tax credit are both mechanisms to reduce tax liability, but they operate fundamentally differently. A tax loss carryforward, such as a net operating loss or capital loss carryforward, reduces your taxable income. This means it lowers the base upon which your tax is calculated. For instance, if you have $100,000 in taxable income and apply a $50,000 tax loss carryforward, your new taxable income is $50,000, and your tax is then calculated on that lower amount. In contrast, a tax credit directly reduces the amount of tax you owe, dollar for dollar, after your tax liability has been calculated. If you owe $10,000 in taxes and have a $1,000 tax credit, your tax bill immediately drops to $9,000. Therefore, a tax credit generally provides a more direct and often more impactful reduction in taxes than a tax loss carryforward, as the latter's benefit is dependent on your marginal tax rate.

FAQs

How long can a tax loss carryforward be used?

For most net operating losses and capital losses generated in tax years beginning after 2017, they can generally be carried forward indefinitely, meaning there is no expiration date on their use.

Can a tax loss carryforward eliminate my tax bill entirely?

A tax loss carryforward can significantly reduce your tax bill, but for most net operating losses incurred after 2017, they are limited to offsetting 80% of your taxable income in any given year. This means you will still owe tax on at least 20% of your income, even with a large carryforward. For individuals, capital losses carried forward can offset future capital gains entirely, but only up to $3,000 of ordinary income annually.

Is tax loss carryforward the same as tax-loss harvesting?

Tax-loss harvesting is a tax strategy employed by investors to intentionally sell investments at a loss to realize a capital loss. This realized loss can then be used to offset capital gains and a limited amount of ordinary income. If the losses exceed the amounts used in the current year, the unused portion becomes a tax loss carryforward, which is the specific tax attribute carried to future years. Tax-loss harvesting is the action of generating losses, while tax loss carryforward is the result or provision that allows those unused losses to be applied later.