Tax loss carryforwards

What Is Tax loss carryforwards?

Tax loss carryforwards are a provision in tax law that allows individuals and businesses to use a net operating loss (NOL) from one tax year to offset taxable income in future tax years. This mechanism falls under the broader category of taxation and is a key component of financial planning and corporate financial management. When a taxpayer's allowable deductions exceed their gross income in a given year, creating a net operating loss, the tax law permits this loss to be carried forward, effectively reducing future taxable income and associated tax liabilities.

History and Origin

The concept of allowing businesses and individuals to account for losses over multiple periods has evolved significantly in tax codes worldwide. In the United States, rules governing tax loss carryforwards have undergone various changes, reflecting economic conditions and policy objectives. Historically, taxpayers were often allowed to both "carry back" losses to prior profitable years to obtain refunds and "carry forward" losses to future years. A significant change occurred with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA generally eliminated the ability to carryback net operating losses for most taxpayers, but it permitted NOLs to be carried forward indefinitely. Additionally, it introduced an 80% limitation on the amount of taxable income that could be offset by NOLs in a given year for losses arising after 2017.¹⁹,¹⁸

However, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted in 2020, temporarily modified these TCJA provisions. It allowed NOLs arising in 2018, 2019, or 2020 to be carried back five years, and it temporarily suspended the 80% taxable income limitation for those years.¹⁷,¹⁶ These legislative shifts underscore how tax loss carryforwards are adapted in response to economic cycles and policy goals, aiming to provide relief during downturns or to encourage certain economic behaviors.

Key Takeaways

• Tax loss carryforwards allow net operating losses from one year to reduce taxable income in subsequent years.
• This provision provides tax relief and can improve cash flow for businesses and individuals experiencing financial setbacks.
• Rules for tax loss carryforwards, including carryback periods and limitations on use, have varied significantly over time due to legislative changes.
• They are particularly relevant for new businesses, those in volatile industries, or individuals with significant capital losses.
• Proper management of tax loss carryforwards is a crucial aspect of effective tax planning.

Interpreting the Tax Loss Carryforwards

Interpreting tax loss carryforwards primarily involves understanding how they reduce future taxable obligations. When a business or individual incurs a net operating loss, this loss isn't merely erased at year-end. Instead, it becomes a deferred tax asset, representing a future tax benefit. The value of this asset depends on the entity's ability to generate sufficient future taxable income against which the loss can be offset.

For corporations, a substantial carryforward indicates past losses but also potential future tax savings. The presence and size of tax loss carryforwards can influence a company's valuation, as they can reduce future effective tax rates. For individuals, these carryforwards are critical in managing personal income tax burdens, especially when large investment losses or significant business deductions occur. Taxpayers must meticulously track these amounts to ensure they are properly utilized within the prevailing tax laws, which may include limitations on the percentage of income that can be offset or the duration for which the losses can be carried forward.

Hypothetical Example

Consider "Green Innovations Inc.," a startup company. In its first year of operation, 2024, Green Innovations incurs substantial research and development costs, leading to a net operating loss (NOL) of $500,000. For simplicity, assume no carryback provisions apply.

1. Year 1 (2024):

   • Revenue: $100,000
   • Expenses (including R&D): $600,000
   • Net Operating Loss: ($500,000)
   • Taxable Income: $0 (due to loss)
   • Tax Loss Carryforward: $500,000

2. Year 2 (2025): Green Innovations begins to commercialize its products and generates a profit.

   • Revenue: $800,000
   • Expenses: $300,000
   • Pre-Tax Income: $500,000

   Under current tax law, for NOLs arising after 2017, only 80% of taxable income can generally be offset by a carryforward.

   • 80% of Pre-Tax Income: $500,000 * 0.80 = $400,000
   • Tax Loss Carryforward used: $400,000
   • Taxable Income (after NOL deduction): $500,000 - $400,000 = $100,000
   • Remaining Tax Loss Carryforward: $500,000 - $400,000 = $100,000

3. Year 3 (2026):

   • Revenue: $900,000
   • Expenses: $350,000
   • Pre-Tax Income: $550,000
   • 80% of Pre-Tax Income: $550,000 * 0.80 = $440,000
   • Tax Loss Carryforward used: The remaining $100,000
   • Taxable Income (after NOL deduction): $550,000 - $100,000 = $450,000
   • Remaining Tax Loss Carryforward: $0

In this example, the initial $500,000 tax loss carryforward substantially reduced Green Innovations' taxable income over two subsequent years, providing significant tax savings as the company became profitable.

Practical Applications

Tax loss carryforwards have several practical applications across various financial domains:

• Corporate Financial Management: Businesses, especially those in cyclical industries or startups with high initial investment and research costs, frequently rely on tax loss carryforwards to manage their tax burden. This allows them to recoup some of the losses incurred during lean years by offsetting future profits, thereby improving cash flow and potentially supporting continued investment. For example, the interplay between the Research and Development (R&D) tax credit and net operating loss carryback provisions can be complex, but strategic utilization can lead to substantial tax benefits.¹⁵
• Individual Tax Planning: Individuals can also generate losses that result in carryforwards, most commonly from business activities or significant capital losses from their investment portfolio. While capital losses can offset a limited amount of ordinary income ($3,000 per year in the U.S.), any unused amount can be carried forward indefinitely to offset future capital gains or ordinary income. This is a core component of "tax loss harvesting," a strategy employed by investors. The Bogleheads Wiki provides a good overview of this strategy for long-term investors.¹⁴
• Mergers and Acquisitions (M&A): Tax loss carryforwards can be a valuable asset in M&A transactions. An acquiring company might seek to acquire a target company with significant NOLs to use those losses to offset its own future taxable income, a practice often referred to as "NOL trafficking." However, tax laws, such as Section 382 of the U.S. tax code, impose strict limitations on the use of NOLs following a change in ownership to prevent such abuses.¹³
• Government Fiscal Policy: Governments may adjust rules for tax loss carryforwards as part of broader economic stimulus packages. For instance, temporary changes made during the COVID-19 pandemic allowed businesses to carry back net operating losses, providing immediate liquidity.¹²,¹¹ This demonstrates how these provisions can be used as a fiscal tool to support businesses during economic downturns.

Limitations and Criticisms

While tax loss carryforwards offer valuable tax relief, they are not without limitations and criticisms:

• Expiration Periods: Historically, tax loss carryforwards often had expiration periods (e.g., 20 years). If a business or individual did not generate sufficient taxable income within that timeframe, the unused losses would expire, becoming worthless. Although U.S. federal law generally allows indefinite carryforwards for losses incurred after 2017, the 80% adjusted gross income limitation can still delay full utilization, especially for very large losses.¹⁰
• 80% Limitation: For many losses incurred after 2017, the ability to offset only 80% of future taxable income means that a portion of income will always be subject to tax, even if substantial carryforwards exist. This can reduce the immediate benefit of the carryforward and prolong the period over which the loss can be fully utilized.⁹,⁸
• Changes in Tax Law: As demonstrated by the TCJA and CARES Act, tax laws related to carryforwards are subject to change. Such changes can alter the value and utility of existing carryforwards, creating uncertainty for long-term financial planning. These legislative shifts can influence investment decisions and corporate strategies.⁷,⁶
• Complexity: The rules surrounding net operating losses and carryforwards can be highly complex, requiring detailed record-keeping and professional tax advice to ensure compliance and maximize benefits. This complexity can be a burden, particularly for smaller businesses.
• Economic Impact: Some academic research suggests that the presence and design of tax-loss carryforward rules can influence corporate investment and risk-taking behavior.⁵,⁴ Critics sometimes argue that overly generous provisions could incentivize risky behavior or create inefficiencies in the tax system.

Tax loss carryforwards vs. Tax Loss Harvesting

While related to managing losses for tax purposes, tax loss carryforwards and tax loss harvesting are distinct concepts.

In essence, tax loss harvesting is a strategy that often generates losses that, if not fully utilized in the current year, then become tax loss carryforwards.

FAQs

What is the main purpose of tax loss carryforwards?

The main purpose of tax loss carryforwards is to smooth out the tax treatment of income over multiple years. It acknowledges that businesses and individuals may experience years of losses that should be considered when assessing their overall profitability and tax liability. This prevents a situation where a profitable entity that experiences an occasional loss year would pay disproportionately high taxes in its profitable years.

How long can you carry forward a tax loss?

For net operating losses incurred in tax years beginning after December 31, 2017, the Tax Cuts and Jobs Act (TCJA) generally allows these losses to be carried forward indefinitely.³,² However, for capital losses incurred by individuals, any unused losses can also be carried forward indefinitely. It's crucial to consult current tax laws as these rules can change based on legislation.

Can individuals use tax loss carryforwards?

Yes, individuals can use tax loss carryforwards. This most commonly occurs when an individual incurs capital losses from investments that exceed their capital gains plus the $3,000 annual deduction against ordinary income. Any amount of this excess capital loss can be carried forward indefinitely to offset future capital gains or the annual $3,000 ordinary income deduction.¹ Individuals who operate businesses as sole proprietors or through pass-through entities can also generate and utilize net operating losses that can be carried forward.

Do tax loss carryforwards expire?

For net operating losses incurred after 2017 under U.S. federal tax law, the carryforward period is generally indefinite. However, some older losses may still be subject to prior rules that had expiration periods (e.g., 20 years). Additionally, rules for specific types of losses or those in other jurisdictions may still have expiration dates. It is essential to identify the tax year the loss was incurred to determine the applicable rules.

How do tax loss carryforwards impact a company's financial statements?

On a company's balance sheet, tax loss carryforwards are typically recognized as a deferred tax asset. This asset represents the future tax savings the company expects to realize by using the carryforwards to reduce future taxable income. The valuation of this asset requires careful consideration, as its realization depends on the company generating sufficient future profits.