A Net Operating Loss (NOL) occurs when a business’s allowable tax deductions and expenses exceed its taxable income in a given year, resulting in a negative taxable income. Instead of losing the tax benefit of that loss, the IRS permits businesses to apply the NOL to other tax years via carrybacks or carryforwards, helping smooth tax liabilities over fluctuating profit cycles.

What Is a Net Operating Loss (NOL)?

Simply put, an NOL happens when a business spends more on deductible expenses than it earns in revenue in a tax year. For example, if a small business spends $50,000 in expenses but only generates $30,000 in sales, it incurs a $20,000 NOL.

How Do Carrybacks and Carryforwards Work?

The Internal Revenue Service (IRS) allows businesses to utilize NOLs in two main ways:

  • Carrybacks: Apply losses to prior profitable tax years to claim a refund for taxes previously paid.
  • Carryforwards: Apply losses to future years to reduce taxable income and thus lower tax bills when the business returns to profitability.

This flexibility helps businesses manage their tax burdens during volatile income periods.

Current NOL Rules and Limitations

Before the Tax Cuts and Jobs Act (TCJA) of 2017, NOLs could generally be carried back two years and carried forward up to 20 years with full deductions allowed. However, TCJA eliminated most carrybacks for losses arising after 2017, permitting indefinite carryforwards but limiting the deduction to 80% of taxable income annually.

The CARES Act of 2020 temporarily reinstated five-year carrybacks for NOLs arising in 2018, 2019, and 2020 to aid businesses impacted by the COVID-19 pandemic.

Using NOL Carrybacks in Practice

When a business experiences an NOL in a current year, it can file an amended return or a special application (like Form 1139 for corporations) to carry that loss back to previous profitable years. This action can trigger a tax refund for taxes paid in those years, providing valuable cash flow relief during downturns.

Using NOL Carryforwards in Practice

If a business cannot or chooses not to carry losses back, it can carry them forward indefinitely (under current law) to offset future income. This helps reduce taxable income and taxes owed in profitable years that follow.

Examples

  • Startup Losses: A startup may have large initial expenses causing a substantial NOL. These losses can be carried forward to offset income in future years as the business grows.

  • Seasonal Businesses: Companies with fluctuating seasonal profits, such as a snow removal service, can strategically use NOL carrybacks to recover taxes from previous profitable seasons and carryforwards to reduce taxes in upcoming profitable seasons.

Who Can Claim NOLs?

Most business entities, including sole proprietorships, partnerships, S corporations, and C corporations, can claim NOL deductions on their tax returns. However, there are specific rules and limitations depending on the entity type and current tax regulations.

Tips to Optimize NOL Usage

  • Keep detailed records of income and expenses to substantiate NOL claims.
  • Consult a tax advisor to navigate complex and evolving NOL regulations and to decide when to use carrybacks or carryforwards.
  • Be aware of the TCJA’s 80% taxable income limitation on NOL deductions.
  • File amended returns promptly if claiming carrybacks to avoid missing refund claims.

Common Misconceptions

  • Not all losses qualify as NOLs — only business operating losses that meet specific IRS criteria.
  • Post-TCJA, carrybacks are generally disallowed except under special provisions like the CARES Act.
  • Failure to file amended returns can forfeit potential tax refunds.

Frequently Asked Questions

How far back can I carry back an NOL? Generally, carrybacks are disallowed after 2017 except for certain pandemic-related losses (2018-2020), which allow a five-year carryback under the CARES Act.

Can NOLs be carried forward indefinitely? Yes, most post-2017 NOLs can be carried forward indefinitely but are limited to deducting up to 80% of taxable income annually.

Do NOLs affect estimated taxes? Yes, claiming NOLs can lower estimated tax payments by reducing taxable income.

Summary of NOL Treatment

Feature Carrybacks Carryforwards
Years Available Generally none except 5 years for 2018-2020 losses Indefinite
Tax Refund Impact Potential refund from prior years Reduces taxable income in future years
Deduction Limit Full pre-TCJA; limited now Limited to 80% of taxable income annually
Applicability Limited to special years/types Most business losses

For more detailed guidance, see our Net Operating Loss (NOL) glossary entry.

Sources

  • IRS: Net Operating Losses (https://www.irs.gov/businesses/small-businesses-self-employed/net-operating-loss-nol-deductions)
  • IRS CARES Act Information (https://www.irs.gov/newsroom/tax-relief-under-the-cares-act)
  • Investopedia: Net Operating Loss (NOL)

Net Operating Loss carrybacks and carryforwards are essential tax tools that help businesses manage income swings by applying losses across tax years, ultimately reducing overall tax liability and improving cash flow.