Net operating losses can be confusing. In this article I am going to explain what they are and what tax benefits can be obtained from NOLs.
There are different types of losses. For a loss to be a net operating loss, it must relate to the operation of a business, farm, ranch, doctor’s office, etc., to make a profit. Nonprofits and hobbies, by definition, cannot have a NOL.
According to basic accounting theory, income minus expenses equals net income (or net loss). Corporations and partnerships can have NOLs, but this article will focus on one owner submitting a List C.
The first tenet of a NOL is that it relates to the running of a business.
Second, an NOL is not an investment (capital) loss. Investors remember the spring of 2000 and fall of 2008 when many stocks of stocks lost half or more of their value. Capital gains and losses are reported in Appendix D of Form 1040. Capital loss deductions are capped at $ 3,000 per year with the balance carried forward indefinitely.
They are offset against capital gains annually; However, many people will not live long enough to deduct the huge capital losses they suffered in 2000 or 2008 (unless tax laws change).
Third, a company’s net loss in the current year is technically not the same as a NOL. The calculation of a NOL for a given tax year involves many factors and can be reduced by other parts of that tax return.
Appendix A of Form 1045 calculates the current year NOL. It begins in line 1 with a loss resulting from the adjusted gross income minus the permitted standard or individual deduction for that year. Several adjustments and 23 lines later, this form shows the current NOL, which can either be withdrawn or carried forward.
Fourth, NOLs appear to be an attempt at fairness by applying a tax break to an earlier or future tax year. An NOL of the current year applied to a previous year is referred to as a carryback; when it is applied to a future year, it is called a lecture. In general, before 2018, NOLs could be carried back by companies for two years or by farmers for five years. The transfers require a choice and are effective for up to 20 years.
The Tax Cuts & Jobs Act (TCJA) restricts NOLs from tax year 2018. However, the CARES Act, passed in 2020, overruled most of the provisions of the TCJA that deal with NOLs. The CARES Act also extended the carry-back period for the 2018-20 tax years to five years. The purpose of this part of the CARES Act was to allow business owners who have been negatively affected by COVID to get a refund of taxes they had paid in previous years.
For example, a 2018 NOL of $ 100,000 was non-refundable when this tax return was created in 2019. But now (following the passage of the CARES Act) that NOL can be rolled back five years to 2013 to offset seven years of taxes paid after the original filing. In 2013, if taxpayers were in the 33% federal tax bracket, they will receive a $ 33,000 refund based on the $ 100,000 NOL carryback for 2018 to 2013.
You may scratch your head. I will summarize. Tax laws in effect in 2018 prevented the $ 100,000 NOL from being carried back. However, the legislation has changed the NOL rules for the 2018-20 tax years. So in our example, the tax law changed two years after filing the 2018 tax return, which then made it possible to change an otherwise dead tax year to get a refund of $ 33,000 in 2013 income tax.
Is your brain twisted already? Hopefully you agree that it is not logical and pointless, but so is tax law. In the US, taxes are approved by Congress. Hence, taxes are limited to the imagination of Congress and their perceived possible political penalties.
Now let’s look at proactive tax planning strategies with NOLs. Let’s start with a review of the federal tax rates that will apply in 2021. The following seven tax rates apply to taxable income greater than zero: 10%, 12%, 22%, 24%, 32%, 35% and 37%. There are also three federal tax rates that only apply to long-term capital gains: 0%, 15%, and 20%. The key is to apply deductions to the tax years with the highest effective tax rate.
For example, let’s again assume a NOL of $ 100,000 for 2018, if you had no taxable income in the 2013-2017 tax years, there are no previously paid taxes to be refunded. Hence, you would choose to present this NOL. If your effective tax rate for the 2013 to 2017 tax years was 10% and your company’s income has risen significantly for 2021 and you are expected to be in the 35% tax bracket for 2021, your extended 2020 would be 1040. submit an election to continue the NOL. Why file an amended declaration to take back your NOL to offset income that was only taxed at 10% when you can offset current or future income that you expect to be taxed at 35% or 37%?
Conversely, if COVID has severely damaged your business and the future is bleak, you will likely want to carry back recent losses to get refunds for taxes previously paid.
In conclusion, net operating losses are not straightforward, but can be used to get refunds for previously paid taxes to offset large tax bills in the future.
Aric Schreiner, CPA, PFS, Certified Tax Strategist, helps successful professionals and small business owners with strategy to reduce taxes and audit risks.