The Net Operating Loss Carryback and Carryforward

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The Net Operating Loss Carryback and Carryforward

Overview of the Net Operating Loss Carryback and Carryforward

If you have a net operating loss (NOL) on your tax return, then you can likely use the loss as a tax deduction in a different tax period when you have taxable income, thereby reducing your tax liability.

An NOL should first be carried back and applied against taxable income recorded in the two preceding years, with any remaining amount being carried forward for the next twenty years, when it can be offset against any reported taxable income. If there is still an NOL left after the twenty years have expired, then the remaining amount can no longer be used. You can also irrevocably choose to ignore the carryback option and only use it for carryforward purposes (which may make sense if you had minimal taxable income in the prior two years). If you choose to waive the carryback option, attach a waiver statement to your tax return for the NOL year.

The standard procedure is to apply all of the NOL against the income reported in the earliest year, with the remainder carrying forward to each subsequent year in succession until the remaining NOL carryforward has been exhausted. If an NOL has been incurred in each of multiple years, then they should be applied against reported income (in either prior or later years) in order of the first NOL incurred. This rule is used because of the twenty-year limitation on an NOL carryforward, so that an NOL incurred in an earlier year can be used before it expires.

The Section 382 Limitation

The NOL carryforward is a valuable asset, since it can be used for many years to offset future earnings. A company buying another entity that has an NOL carryforward will certainly place a high value on the NOL carryforward, and may even buy the entity strictly in order to use its NOL carryforward. To curtail this type of behavior, the IRS has created the Section 382 limitation, under which there is a limitation on the use of an NOL carryforward if there is at least a 50% change in the ownership of an entity that has an unused NOL. The limitation is derived through a complex formula that essentially multiplies the acquired corporation’s stock times the long-term tax exempt bond rate. To avoid this problem, a company with an unused NOL carryforward that is seeking to expand its equity should consider issuing straight preferred stock (no voting rights, no conversion privileges, and no participation in future earnings) in order to avoid any chance that the extra equity will be construed as a change in ownership.

The Short Year Net Operating Loss

If a company has incurred an NOL in a short tax year, it must deduct the NOL over a period of six years, starting with the first tax year after the short tax year. This limitation does not apply if the NOL is for $10,000 or less, or if the NOL is the result of a short tax year that is at least nine months long, and is less than the NOL for a full twelve-month tax year beginning with the first day of the short tax year. This special NOL rule was designed to keep companies from deliberately changing their tax years in order to create an NOL within a short tax year. This situation is quite possible in a seasonal business where there are losses in all but a few months. Under such a scenario, a company would otherwise be able to declare an NOL during its short tax year, carryback the NOL to apply it against the previous two years of operations, and receive a rebate from the IRS.