Updated July 10, 2023
What is Tax Loss Carry Forward?
The term “tax loss carry forward” refers to the mechanism individuals can use to reduce tax implications on future profits by carrying forward losses from preceding years to offset future profits.
A separate account is created to capture the cumulative tax loss booked during a given period, which can eventually be used in future years to reduce tax payments until the cumulative tax loss becomes zero.
Explanation of Tax Loss Carry Forward
A business incurs tax loss when the business expenses for a given period exceed the corresponding revenue. In contrast, an individual incurs tax loss when the claimed deductions for a given period exceed the total assessable income for the same period. It is a provision that allows individuals to use the losses incurred in prior years to reduce tax payments in future years by offsetting the profit earned. The claimant can continue to offset the future profits even if the source of the loss ceases to exist, such as the shutdown of the business that recognized the losses.
Purpose of Tax Loss Carry Forward
The underlying purpose of tax loss carry forward is fairly plain and simple. The total taxes paid during a lifetime should be proportionate to the total net earnings (= profits – losses) recognized during the lifetime, irrespective of the distribution of the profits and losses during the period.
How Does Tax Loss Carry Forward Work?
The impact of tax loss carryforward on tax calculation is opposite to that of profit. This provision effectively creates future tax relief for individuals. The tax losses can be carried forward for up to 7 years in most cases; however, there are instances where the rules vary slightly. For example, suppose an individual cannot offset the loss from one business with the profit from another in the same year. In that case, the individual can carry the loss to the following assessment years.
Examples of Tax Loss Carry Forward (With Excel Template)
Let’s take an example to better understand the Tax Loss Carry Forward calculation in a better manner.
Example #1
Let us take a simple example of an individual who incurred a loss of $500 last year while booking a profit before tax of $800 in the current year. First, determine the tax relief the individual enjoys in the current year if the applicable tax rate is 30%.
In this case, the total taxable income in the current year will be $300 (= $800 – $500), which is how tax loss carries forward works.
So, the tax payment in the current year will be $90 (= 30% * $300). However, the tax payment would have been $240 without the provision (= 30% * $800).
Therefore, the provision has resulted in tax relief of $150 (= $240 – $90).
Example #2
Let us take the example of David, who started a bottle manufacturing firm five years back. During its first year of operation, the company incurred a loss of $2.5 million. However, it started generating profit in the second year. The applicable tax rate for David is 35%. Determine the tax relief enjoyed by David if the company posted the following profit before tax in the subsequent years:
- Year 2: $0.3 million
- Year 3: $0.9 million
- Year 4: $2.0 million
- Year 5: $2.5 million
The below table shows the computation of tax relief. (explain in Excel template)
| Particulars (in 000s) | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
| Profit before tax | -$2,500 | $300 | $900 | $2,000 | $2,500 |
| Cumulative earnings | -$2,500 | -$2,260 | -$1,540 | $460 | $2,960 |
| Taxable income | $0 | $60 | $180 | $460 | $2,500 |
| Tax rate | 35% | 35% | 35% | 35% | 35% |
| Tax payment (before provision) | $0 | $105 | $315 | $700 | $875 |
| Tax payment (after provision) | $0 | $21 | $63 | $161 | $875 |
| Yearly tax relief | $0 | $84 | $252 | $539 | $0 |
| Cumulative tax relief | $0 | $84 | $336 | $875 | $875 |
Therefore, David saved a tax payment worth $875,000 due to the tax loss carry forward provision.
Who Will Use Tax Loss Carry Forward?
Individual partners in a partnership firm or sole traders can use this provision to offset business losses against profit earned in future years. Further, even those individuals who operate through a trust or a company can enjoy this provision’s benefits and carry forward tax losses in any given year to future years.
Tax Loss Carry Forward Limit
There are two major limits that an individual should follow while using tax loss carry forward:
- The tax loss carried over in any given year is limited to 80% of the taxable income computed before offset.
- The tax loss can be carried forward for seven years that follow immediately after the year the loss has been incurred.
Advantages
Some of the major advantages are as follows:
- This provision of tax loss carryforwards results in significant tax relief.
- It reduces cash outflow for tax payments, which supports the business’s liquidity.
Disadvantages
Some of the major disadvantages are as follows:
- The benefits of loss can’t be passed onto the descendants upon the concerned person’s death.
- Federal tax and state and local laws make it a complex and time-consuming exercise.
Conclusion
So, it can be seen that tax loss carried forward is a very important financial provision as it helps individuals manage their tax obligations. But given that the benefits can be enjoyed over a long period, it is important to maintain a proper record of all the related documents.
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