Small businesses go through cycles. Some years, your business might be very profitable. Other years, you might lose money. To help business owners smooth out these swings, the IRS lets them transfer losses to other years as an extra deduction through net operating loss carryforward and carryback. Here’s how it works.
Net Operating Loss Carryforward and Carryback
The IRS doesn’t tax a business’s total sales revenue. It taxes the business’s profit. If you own your business, you can deduct the costs of operating it, such as employee salaries, equipment and rent or mortgage payments.
In some years, your expenses could end up higher than your revenue, leaving you with a net operating loss. For example, if you paid for a business expansion that cost more than your sales revenue for the year, and took out a small business loan to cover the difference, you couldn’t deduct any expenses that year beyond your revenue.
But you can turn your net operating loss into a tax break, as the IRS lets you deduct the loss from your income on another year’s tax return. With a net operating loss carryforward, you save your net operating loss deduction for your future earnings. With a net operating loss carryback, you can claim it against taxes paid in earlier years, giving you a retroactive refund.
Claiming Your Losses
If your business has a net operating loss, you can carry it forward indefinitely until you claim it against your business income.
Carrybacks are a little less flexible. If your business suffered a loss in 2018, 2019 or 2020, you could carry back that loss up to five years. Under the current laws, there is no way to carry back losses from 2021 and beyond.
If you took a net operating loss between 2018 and 2020, you could claim net operating loss deductions up to 100% of your profit in other tax years, according to the IRS. For losses in the 2021 tax year and beyond, your net operating loss deduction is limited to 80% of your taxable income.
Deducting Your Net Operating Loss
Let’s say that Jordan owns several beauty salons. In 2019, she earned a net operating profit of $2 million. But in 2020, she had a $1 million net operating loss because of the COVID-19 pandemic. She has a couple of options for using her net operating loss deduction.
She could claim her deduction against her 2019 income, which would cut her taxable income in half ($2,000,000 − $1,000,000 = $1,000,000). Assuming her business is in a 21% tax bracket, the IRS would send her a refund for $210,000.
She could also carry forward the net operating loss deduction and apply it to up to 100% of her 2021 income.
Now, let’s say that Jordan experiences another $1 million operating loss in 2021. Under the current rules, she could not carry back that deduction. She would need to carry it forward, and the deduction would be limited to 80% of her income. If she earned $1 million in profit in 2022, she could only deduct $800,000 of her 2021 losses.
Maximizing Your Loss Deduction
Maximizing your net operating loss deduction is about timing. If you paid taxes on your profits in the past few years, using the temporary net operating loss carryback is a way to retroactively reduce your taxable income and get a cash refund. If you think that your profits and your tax bracket will be higher in the future, it might better to use the deduction later.
The carryforward and carryback rules changed significantly in the past four years with the passing of the Tax Cuts and Jobs Act and the CARES Act. And with a new administration, more changes are possible. If you plan on taking a net operating loss deduction, check the most recent tax news online when you prepare your return.
Given the high value of this deduction and the rule changes, you should work with an accountant to plan your strategy. They can identify deductions and find out when it’d benefit your business most to claim them.