Updated July 3, 2023
Definition of Net Operating Loss
Net Operating Loss occurs when a company’s taxable income doesn’t exceed its allowable deductions in a tax period. This credit of Net operating loss can be carried forward to subsequent years by the company. It will set off the taxable income of the company in the following years thereby reducing the company’s tax liability.
Explanation
Most businesses do not make money in their initial years. So, to provide tax relief mainly to those businesses, the concept of Net Operating loss comes into the picture. When allowable deductions in the company are more than the company’s taxable income in a tax period, it results in a Net Operating Loss. The company carries forward this loss to subsequent years, which lowers the profits of the following years and reduces its future tax payable.
How to Calculate Net Operating Loss?
When we deduct allowable deductions from the taxable income, resulting in a negative number, we get Net Operating Loss. The steps to compute Net Operating Losses are as follows:
Determination of Eligibility
Generally, the taxpayer can reduce their profit from their losses. The individual and C Corporation can claim net operating loss (Here, Corporation and owner both have to pay taxes on their income). The deduction of Net Operating loss cannot claim by the partnership firms and S corporation (it has some tax benefits). Members, stockholders, or partners of partnership firms or S Corporations can claim these deductions from their share of income.
Calculation of Net Operating Loss
Only allowable deductions are deductible from taxable income while calculating Net Operating Losses. The following items included in the computation of taxable income are not included while calculating Net Operating Loss:
Excess of non-business deduction over non-business income. Excess of capital losses over capital gains
The following items are added back to the negative taxable income of the taxpayer and not included in the calculation of net operating loss:
- personal expense
- excess of non-business deduction over non-business income
- excess of capital losses over capital gains
- Brought forward Net operating loss deduction
- Gain from the sale of stock from qualified small businesses.
- Deduction from household production activities
After considering the above item, the amount of Net Operating Loss is determined. For example: If the taxpayer’s taxable income is $100,000 and allowable deductions are $140,000, its Net Operating Loss is $40,000 ($140,000-$100,000). So, there is no requirement to pay tax.
Now, suppose the business earns a profit of $40,000 in the subsequent year. It has to pay the tax on the taxable profit, which is $40,000*30% =$12,000(assuming the tax rate to be 30%). But as the business has lost in previous years, reducing the tax liability in the subsequent year will be useful.
Carry Forward or Cary Back
The Net Operating losses are carried forward to 20 years after the NOL year and back to two years before the NOL year. After the lapse of 20 years, the business cannot avail of further deduction of any portion of that NOL. At their discretion, companies can avail themselves of the carry forward option only and waive the carrying back period. But after the TCJA (Tax Cuts and Job Act) imposition in 2018, these losses can be carried forward for indefinite years. Up to 80% of the taxable income next year can be useful to reduce the next year’s taxable income.
Example of Net Operating Loss
Suppose a company has a taxable income of $1,000,000, an allowable deduction of $1,800,000 in 2020, and a taxable income of $900,000 in the next year. Calculate the Net Operating Lease and its treatment in the Company’s Books of Accounts.
Solution:
In the Year 2020,
|
Transaction |
Amount |
| Taxable Income | $1,000,000 |
| (-)Allowable Deduction | $1,800,000 |
| Net Operating Loss | -$800,000 |
There is no company tax liability in the current year as the company has incurred losses. Instead, these losses are carried forward to the next year and recorded as deferred tax assets on the balance sheet. This total amount ($800,000) is carried forward to the balance sheet for next year, but losses up to only 80% of the taxable income ($900,000) of next year are useful to reduce the taxable income for the following year.
So, $800,000 is recorded as a deferred tax asset in the balance sheet for 2020. Therefore, it is carried forward to the following year’s balance sheet.
Next year,
|
Transaction |
Amount |
| Net income for next year | $900,000 |
| (-)Net operating losses carried forward from the previous year ($900,000*80%) | $720,000 |
| Taxable income for next year | $180,000 |
The deferred tax asset of $80,000 ($800,000-$720,000) remained on the company’s balance sheet and was carried forward the following year.
Reasons for Net Operating Loss
- Net operating losses generally occur because of the losses incurred in the regular operation of the business when allowable deduction exceeds taxable income. This typically happens when there is a cyclic business in the company.
- Also, when the company is in its initial phase of business, there are chances of incurring net operating losses because it generally takes some years to set up the business properly and earn profits.
- Some other causes may also contribute to it, including Natural Calamities, Damages to Property, theft, etc.
Uses
Sometimes the company makes Losses in a year. So to provide tax relief to the taxpayer, these losses can be carried forward to subsequent years. The profit of the following years reduces and reduces the future tax liability of the taxpayer.
Advantages
The main advantage of the Net operating Losses is that they can be carried forward to the next year and recorded as deferred tax assets on the company’s balance sheet. This also helps the company to reduce its future tax liability by offsetting the losses from the taxable income of subsequent years. This asset account can be reduced yearly by not exceeding eighty percent of the taxable income in the next year. This process goes on until the balance of the asset account exhausts.
Disadvantages
NOL helps the company to reduce its future taxable income. Thus, it is a valuable asset. Some companies acquire companies having substantial NOL for availing of tax benefits. Still, there are some restrictions that the IRS imposes if a company with net operating losses transfers its 50% ownership to another company, so in that case, only some part of NOL can be used by the acquiring company in each coincident year.
Conclusion
Thus, it provides a tax benefit to the company in the form of a reduction of tax liability in the subsequent year. These losses are carried forward for indefinite years, but 80% of the taxable income in the following years is useful to reduce the taxable income of the subsequent year. Finally, it results in a reduction of the future tax liability of the company.
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