A net operating loss occurs when a business has more expenses than revenues. Otherwise known as NOL, it’s a way to bring tax relief to businesses that aren’t profitable in a tax year.
Before 2018, businesses could use losses from one year to lower their tax bill in years they were profitable. And they could choose to apply their NOLs to future or past years.
But the Tax Cuts and Jobs Act made changes to Section 172 and the application of NOLs. Here’s what you should know in order to strategically use NOLs in 2018 and beyond.
Old NOL rules
Before the Tax Cuts and Jobs Act passed, businesses could carry NOLs back two years and forward 20 years. Businesses could reduce 100% of their taxable income.
In a perfect world, a company could use 100% of their NOLs to bring their tax bill down to $0. That probably wasn’t a reality for most businesses, but now it’s not even a possibility. Here’s why.
New NOL rules
The NOL deduction is limited. Businesses can only use 80% of their NOLs to reduce their taxable income. And, they can’t be carried back and applied to past tax years.
If businesses want to carry any NOLs into future years, they must apply them in the very next tax year that the business has positive taxable income.
On the bright side, NOLs can be carried forward forever. They aren’t limited to a 20-year period.
If you have any outstanding NOLs from tax years before 2018, the old rules do apply – 100% application, carry back two years, and carry forward 20 years. Any NOLs you create in 2018 and after are subject to the new law.
What else changed?
Before the Act, losses from nonpassive businesses could offset other sources of income without restrictions. From 2018 to 2025, only corporations can deduct excess business losses. Other business types can’t.
Excess business loss is the net business loss from all activities that are greater than a threshold amount. These thresholds are $250,000 for single filers and $500,000 for married filing joint filers.
If you have losses greater than these amounts, you can carry them forward and treat them like NOLs. However, the 80% limitation applies at the partner and shareholder level, not at the entity level. This rule doesn’t apply to C corporations.
How will this impact me and my business?
This is another piece of the tax law that offsets the 21% corporate tax rate. While your business enjoys a new low tax rate, the government ensures your business pays something in taxes. So it limited the amount of NOLs you can apply.
You may find that your cash flow is more limited and you can’t reduce your taxable income as much as you’d like.
As an individual taxpayer, you experience similar limitations because your excess business losses are treated like NOLs. Plus, if you’re under the threshold amounts listed above, you lose the ability to reduce your taxable income with NOLs.
Who is most affected by the new NOL law?
Businesses that boom and bust. They start out being profitable, then have periods of losses.
Why? Because they can’t carry back any NOLs into past years to bring in cash. And, they can only apply 80% of their NOLs to each current year.
While they can carry them forward indefinitely, they’re still required to pay taxes each year and forfeit the ability to bring in cash when it’s most needed.
Show me an example
Fred owns a business that has a net loss of $50,000 in 2018. In 2019, his business makes a $50,000 profit before taxes.
Under the previous law, Fred would’ve been allowed to deduct the 2018 loss in 2019 and totally eliminate his business’ tax liability.
Now, Fred can only deduct 80%. This equates to $40,000. When he claims the NOL deduction, he reduces his taxable income to $10,000.
$50,000 – $40,000 = $10,000.
The $10,000 of NOL that’s left over becomes a tax asset. It increases his after-tax income in the future.
In 2020, Fred’s business is profitable again. He makes $100,000 and is required to apply the unused NOLs. The $10,000 that he carried forward reduces his taxable income to $90,000.
As straightforward as NOLs may appear, you should understand how this change impacts your business.
What’s your current amount of NOLs? When did you create them? If many are from 2017, how can you use them to your advantage – knowing that the old rules apply? How should you move forward with NOLs in the future?
Connect with your tax professional to understand your exposure to these rules and create a strategy around net operating losses and how they impact other changes in the Tax Cuts and Jobs Act.
Have questions about NOLs? Let’s talk!
