If you’re running a business, whether it’s new or established, it’s possible that you may experience losses. But don’t worry, the federal tax code can help. You have the option of applying your losses to offset taxable income in future years, subject to certain limitations, through the net operating loss deduction.
Qualifying for a Net Operating Loss Deduction
To qualify for the net operating loss (NOL) deduction, your deductions for the tax year should be greater than your income. This deduction is designed to address tax inequities that can exist between businesses with stable income and those with fluctuating income. It essentially lets businesses average out their income and losses over the years and pay taxes accordingly.
You can claim the NOL deduction if the loss is caused by deductions related to your business (Schedules C and F losses, or Schedule K-1 losses from partnerships or S corporations), casualty and theft losses from a federally declared disaster, or rental property (Schedule E). However, capital losses that exceed capital gains, the exclusion for gains from the sale or exchange of qualified small business stock, nonbusiness deductions that exceed nonbusiness income, the NOL deduction itself, and the Section 199A qualified business income deduction are generally not allowed when determining your NOL.
If you are an individual or C corporation, you can qualify for the NOL deduction. However, if you operate a partnership or S corporation, you may not be eligible. Nonetheless, partners and shareholders can still calculate their individual NOLs by using their respective portions of the business’s income and deductions.
Limitations of the Net Operating Loss Rules
The NOL rules underwent significant changes due to the Tax Cuts and Jobs Act (TCJA). Before the implementation of this act, taxpayers could carry back NOLs for two years, and carry forward their losses for 20 years. Additionally, they could apply NOLs against 100% of their taxable income.
Under the TCJA, taxpayers can now only deduct 80% of their taxable income for the year as NOLs and are no longer allowed to carry back NOLs. However, they can carry forward the losses indefinitely. These changes are important to keep in mind while filing taxes.
The temporary relaxation of TCJA restrictions under a COVID-19 relief law has allowed for the carryback of NOLs arising in 2018, 2019, or 2020 for five years. It has also removed the taxable income limitation for years before 2021, enabling NOLs to entirely offset income. However, these provisions are no longer in effect.
If your NOL carryforward is greater than the taxable income for the year you carry it, you may have an NOL carryover. The carryover is the surplus of the NOL deduction over the modified taxable income for the carryforward year. When the NOL deduction includes multiple NOLs, you must use them in the order incurred against your modified taxable income, beginning with the earliest.
Excess Business Losses
The Tax Cuts and Jobs Act (TCJA) introduced a restriction called the “excess business loss” for the tax year 2021. Under this rule, if you’re a partner or shareholder in a partnership or S corporation, the limitation is imposed at your level. It is applied after considering the outside basis, at-risk, and passive activity loss restrictions.
As per the regulations, if you are a noncorporate taxpayer, your business losses can only be used to offset business-related income or gain. Moreover, there is a threshold of $289,000 ($578,000 if married filing jointly) that is adjusted for inflation in which losses can be compensated against. Any remaining losses are carried forward to the next tax year as a net operating loss. However, it’s important to note that these losses are subject to an 80% income limitation on NOLs, which reduces their tax value.
It is worth noting that the excess business loss limitation is applicable to tax years commencing before January 1, 2029, as per the Inflation Reduction Act. Prior to this act, it was set to expire after December 31, 2026, as per the TCJA.
Planning Ahead
Navigating the tax regulations surrounding business losses and the net operating loss deduction can be challenging, especially when considering the impact of net operating losses (NOLs) on other tax benefits. Our tax experts can assist you in determining the optimal path forward.