Net Operating Losses and U.S. Income Taxes
The most common reason for a net operating loss is a loss from operating a business – expenses incurred in the business exceed the revenue generated by the business. This may occur in the first year or years of operation, or during a later year. The deduction of a net operating loss, for U.S. income tax purposes, is available to individuals, estates, and trusts. Partnerships and S corporations generally cannot use net operating losses, but partners and shareholders can take their individual shares of business income and deductions into account in calculating their individual net operating losses.
Figuring a Net Operating Loss
To claim a net operating loss, you must first calculate the amount that can be taken as a deduction to be applied against taxable income from another year. The net operating loss allowable is not necessarily the same as the negative taxable income shown on your tax return for the year.
Deductions Not Included In Net Operating Loss
There are limits that apply, and not all tax deductions are taken into consideration in determining a net operating loss. The following deductions are excluded:
�· Personal exemptions.
�· Section 1202 exclusion of 50% of gains from the sale or exchange of qualified small business stock. Any gain that you excluded is added back in calculating your net operating loss.
�· The excess of non-business capital losses over non-business capital gains, without taking into account the Section 1202 exclusion. Business capital losses can be included in the net operating loss calculation, but only up to a limit. This limit is calculated as the total of your non-business capital gains in excess of your non-business capital losses and excess non-business deductions, and your total business capital gains, after adding back any Section 1202 exclusion.
�· Deductions that are not connected to your trade or business, or your employment. These include deductions for alimony paid, contributions to an IRA or self-employed retirement plan, and the standard deduction, if you do not itemize. If you itemize, some of your deductions are taken into account in calculating a net operating loss and others are not. The net operating loss calculation includes casualty and theft losses, state income taxes on business profits, and employee business expenses.
Deductions Included in Net Operating Loss
If, as a sole proprietor or independent contractor, the expenses connected with your trade or business exceed your revenues, you have a net operating loss. Business deductions for NOL purposes also include some deductions that are not necessarily connected with a trade or business. These deductions include expenses connected with your employment, and certain other losses, such as casualty and theft losses. For purposes of the net operating loss calculation, business deductions include the following:
�· Moving expenses.
�· Employee business expenses that you claim as an itemized deduction. These include work-related travel and entertainment expenses, education expenses, uniforms, tools, and union dues.
�· Casualty and theft losses, on either business or non-business property.
�· Deduction for one-half of the self-employment tax.
�· Deduction for self-employed health insurance.
�· State income tax on profits from your trade or business.
�· Rental losses.
�· Loss on the sale or exchange of real or depreciable business property.
�· Your share of a loss from a partnership or S corporation.
�· Ordinary loss on the sale or exchange of stock in a small business corporation or a small business investment company.
Ã?· The portion of an investment in a pension or annuity plan that is not recovered and is claimed on a decedent’s final income tax return.
Carrybacks and Carryforwards
If you have a net operating loss in the current year, you can carry this loss back to the two preceding tax years and apply the loss against taxable income for those years in order to obtain a refund of the tax you previously paid. Those two years are referred to as the carryback period. If there is still an NOL remaining after carrying it back two years, you can carry forward any remaining NOL balance for up to 20 years after the NOL year. This is called the carryforward period.
You apply the NOL to the first carryback year first. Any balance of the loss that is not used up is then carried forward to the following year. If there is still an unused balance, it is carried forward to the next year, and so on, until the loss is used up.
Longer Carryback Periods
There are certain losses that can be carried back for more than two years. Two types of losses, called eligible losses, can be carried back for three years. These are losses from casualties or theft, and losses from a Presidentially declared disaster for a qualified small business. This is a sole proprietorship or partnership with average annual gross receipts of $5 million or less during the three years ending in the NOL year. If the business is less than three years old, the period the business has been in existence is used to determine if it qualifies as a small business.
Losses from a farming business can be carried back five years. If an overall net operating loss includes a farming loss as well as other deductions, the amount that can be carried back five years is the smaller of the NOL, taking into account only farming income and expenses, or the total NOL for the tax year.
If you have a farming loss, you can choose to waive the 5-year carryback period and carry back the loss for only two years. To make this election, you need to attach a statement to your tax return for the year of the net operating loss, stating that you are choosing to treat the loss as if it were not a farming loss under section 172(i)(3) of the Internal Revenue Code.
Waiving the Carryback Period
You do not necessarily have to carry back a net operating loss to the two prior years if it is not to your advantage. You can choose to carry the loss forward instead. To do this, you must attach a statement to your tax return for the NOL year, indicating that you are choosing to waive the carryback period under section 179(b)(3) of the Internal Revenue Code.
How To Deduct a Carryback Loss
You can use Form 1045, Application for Tentative Refund, to carry back a loss and request a refund. This form is used to claim a refund for all the carryback years for which you qualify. As indicated above, normally you can carry back an NOL for the two preceding years, but if you have eligible losses you can carry that portion of the NOL back three years, and if you have a farming loss you can carry it back five years, if you choose to.
Another option is to file Form 1040X, Amended U.S. Individual Income Tax Return, for each of the carryback years. Estates and trusts that do not use Form 1045 would have to use Form 1041 instead of Form 1040X.
Generally, you will obtain a quicker refund by filing From 1045. You can file this form on or after the due date for filing your return for the NOL year, but no later than one year after the end of the NOL year. If you file an amended return instead, you must file Form 1040X (for individuals) within three years after the due date for filing your return for the NOL year, including extensions.
Re-figuring Your Tax in the Carryback Year
When you carry back an NOL to a prior year, you first apply the NOL against adjusted gross income (AGI) for that year. This affects certain deductions that are functions of AGI, either based on it or subject to a limit expressed as a percentage of AGI.
After applying the NOL to determine the revised AGI for that year, you then re-calculate the following items in the order presented. If more than one of the items applies, you use the AGI after applying the NOL carryback and the effect of the preceding item on the list.
1. Special allowance for passive activity losses from rental real estate activities.
2. Taxable social security and tier 1 railroad retirement benefits.
3. IRA deductions.
4. Excludable savings bond interest.
5. Excludable adoption benefits provided by an employer.
6. Student loan interest deduction.
7. Tuition and fees deduction.
Once you have re-calculated your adjusted gross income, this adjusted AGI is used to re-calculate other deductions that depend on the amount of your AGI, including:
�· Itemized medical expenses.
�· Itemized deduction for sales tax, if you used the table.
�· Itemized deduction for casualty losses.
�· Miscellaneous itemized deductions subject to the 2% of AGI limit.
�· Overall limit on itemized deductions.
�· Phase-out of deduction for exemptions.
How To Report a Carryforward
If you are carrying forward an NOL, individuals would show the carryforward amount as a negative figure on the “Other Income” line of Form 1040. Estates and trusts show the NOL carryforward deduction on Form 1041 together with other deductions not subject to the 2% limit. You will need to attach a statement to your return for the year you are deducting the carryforward amount, showing how you calculated the NOL. And, if you are carrying forward different NOLs, your statement should show them separately.
Married Taxpayers
When you are not married during all years of net operating loss carryback and carryforward periods, only the spouse who had the NOL can claim the deduction. If you file a joint return for any of those years, the NOL is applied only against the taxable income of that spouse. After taking the NOL against that spouse’s income, the joint rates apply on the resulting taxable income.
If you are not married in the year you incur a net operating loss, or you are married to a different spouse, and you carry the loss back to a year in which you were married and filed a joint return, your refund for that year may be limited. Your refund would be the difference between the refigured tax and your contribution to the tax originally paid on the joint return. Your portion of the refigured tax would be determined by calculating the original tax for both you and your spouse as if you had filed separately, and then taking your proportion of the sum of these amounts and multiplying by the refigured tax after applying the net operating loss. Your contribution to the total tax paid for that year, unless you have an agreement with your spouse stating otherwise, would be the amount of tax withheld from your pay and from your other income for that year, plus your share of any estimated tax payments that were made, less your share of the tax refund or plus your share of the tax paid with your joint return for that year.
Net Operating Loss Carryovers
If you carry back or carry forward a net operating loss, and it reduces your taxable income below zero for that year, you will have a NOL carryover. In order to determine how much of the NOL will be used up that year, and how much can be carried forward to the following year, you will need to make certain adjustments to your taxable income. These adjustments are for NOL purposes and do not affect the items as they should be reported on your return for that year. The amount of NOL that you can carry forward would be the amount by which the NOL balance exceeds your taxable income as modified for NOL purposes for that year.
For carryback years, your modified taxable income, and the NOL carryover amount, can be calculated by using Schedule B of Form 1045. This schedule cannot be used for a carryforward year.
If you carry forward an NOL deduction from a prior year to the current year, and this NOL deduction reduces your taxable income for this year to zero, or to a negative amount, you should use the worksheet in Table I of Internal Revenue Service Publication 536 to calculate the amount to be carried over to the following year.
