A tax carryback is a tax provision that lets businesses and, in some cases, individuals apply a net operating loss (NOL) from the current or a recent tax year to prior years’ taxable income. The primary benefit of this mechanism is to obtain a refund of taxes that were paid during profitable years, thus smoothing income fluctuations for taxpayers who experience financial hardships.
How a Tax Carryback Works
When a business or taxpayer incurs an NOL—meaning their allowable business deductions exceed the taxable income for the year—they might be able to “carry back” this loss to past profitable years. By applying the NOL to those years, the taxable income of each preceding year is reduced, potentially generating a refund of taxes previously paid.
For example, under certain legislative provisions such as the CARES Act of 2020, taxable losses for 2018 through 2020 could be carried back up to five years. This means if a business suffered a loss in 2019, it could apply that loss against profits up to five years prior, recovering some or all of the taxes paid in those profitable years.
Historical Context and Recent Changes
Tax carryback rules have evolved over time. Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, businesses had broader ability to carry back losses, often up to two years. The TCJA generally eliminated carrybacks for most taxpayers, shifting focus to carrying forward losses to offset future income indefinitely, but limiting the deduction to 80% of taxable income.
However, the COVID-19 pandemic prompted temporary legislative changes through the CARES Act. This act reinstated five-year NOL carrybacks for certain losses arising between 2018 and 2020 to provide liquidity during economic downturns. Currently, for most NOLs arising after 2020, carrybacks are not permitted, except in specific cases like farming losses.
Who Can Benefit from Carrybacks?
Carrybacks mainly benefit businesses with fluctuating income or sudden losses. These include:
- Small businesses needing immediate cash flow relief
- Startups with inconsistent profitability
- Farmers facing unpredictable risks
- Individuals with business income who file as sole proprietors
These taxpayers can recoup taxes paid in profitable years, which is crucial during financial setbacks.
Filing and Claiming a Carryback
To claim a carryback refund, taxpayers must file an amended tax return for the relevant prior year using IRS forms like Form 1045 for individuals or Form 1139 for corporations. This process recalculates taxable income after applying the carryback and determines the refund amount.
It’s important to note that a carryback refund is not automatic; proactive filing and compliance with IRS rules are required.
Key Differences Between Carrybacks and Carryforwards
Carrybacks reduce taxable income for previous years and may result in immediate refunds. Carryforwards, which are now more common, allow a loss to offset income in future years, thereby reducing future tax liability. Taxpayers often may elect to waive carrybacks to carryforward losses depending on their financial strategy and expected profitability.
Common Misconceptions
- Not all losses qualify for carrybacks: Most NOLs after 2020 typically must be carried forward.
- Carryback refunds require filing: The IRS won’t issue refunds without amended returns.
- Carrybacks are not just for large corporations: Small businesses and sole proprietors may also qualify.
Practical Tips
- Always review current IRS guidelines on NOLs and carrybacks.
- Consult a tax professional to evaluate eligibility and shipping for a carryback.
- Maintain detailed records of losses and prior year profits to support claims.
Additional Resources
For detailed IRS guidance, visit the IRS page on Net Operating Losses (NOLs) and review Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts. These provide comprehensive details on NOL rules, carrybacks, and carryforwards.
Understanding tax carrybacks can be a vital financial tool during economic challenges, offering a way to reclaim taxes paid during profitable years and improve your business’s cash flow.