Loss carryforward and loss carryback

With loss carryforward and loss carryback, you can report net operating losses (NOLs) to the IRS and offset them against your future or past taxable income. It is important to distinguish between the two provisions accurately to avoid errors on your tax return.

What is loss carryforward and loss carryback?

Loss carryforward and loss carryback are valuable tax provisions that help businesses manage net operating losses (NOLs). They allow a company to offset taxable income from past or future years, reducing the total tax liability. Here’s a breakdown of both terms:

• Loss carryforward: When a business incurs a net operating loss (NOL), it can carry that loss forward to future years. This means the company can apply the loss to reduce taxable income in upcoming profitable years, lowering future tax liabilities.

• Loss carryback: In contrast, a business can carry its NOLs back to previous tax years. By doing so, it can apply the loss to past years’ taxable income, which can result in a refund of taxes paid in those years. This provision can provide quick financial relief.

These provisions help businesses avoid paying taxes in years when they are unprofitable, by using those losses to either offset prior taxes (carryback) or reduce future tax payments (carryforward).

How do loss carryforward and loss carryback differ?

While both loss carryforward and loss carryback aim to provide tax relief, the key difference lies in how and when the losses are applied to reduce taxable income:

Loss carryforward

This provision allows businesses to use NOLs to offset taxable income in future years. It’s beneficial when a company anticipates making a profit in the years ahead. The advantage of carrying forward NOLs is that it can provide tax relief for multiple years, as long as the business continues to generate taxable income.

Example: If a business incurs a loss of $200,000 in 2021, and in 2022 it earns $250,000 in taxable income, the business can apply the 2021 NOL to reduce its 2022 taxable income, potentially lowering taxes owed for 2022.

Loss carryback

With carrybacks, the NOL is applied to reduce taxable income in previous years, typically up to 2 years. This can result in a tax refund, allowing businesses to recover some of the taxes they paid in profitable years before the loss occurred.

Example: If a business incurred a $100,000 loss in 2020 but had a taxable income of $150,000 in 2019, the company could apply the 2020 NOL to the 2019 tax year, resulting in a tax refund for the 2019 taxes that were paid.

Loss carryforward explained with an example

Here’s a detailed example to show how loss carryforward works in practice:

Imagine Company A, which has a taxable income of $500,000 in 2020, but due to various factors, it incurs a net operating loss (NOL) of $200,000.

• In 2021, Company A’s taxable income increases to $600,000. Without any tax relief, the company would owe taxes on the full $600,000.
• However, since Company A has a carryforward of $200,000 from the previous year, it can apply this amount to reduce its taxable income for 2021, bringing it down to $400,000.
• This results in lower taxes for 2021, as the NOL reduces the amount of taxable income subject to taxation.

The company can continue to use this carryforward in subsequent years if its taxable income exceeds the NOL amount until the carryforward is fully utilized. In the U.S., businesses can carry forward losses indefinitely, but there is a limit to how much can be offset in any given year. As of recent tax laws, businesses can offset up to 80% of taxable income with carried forward NOLs.

Loss carryback explained with an example

Let’s explore loss carryback with an example:

Imagine Company B, which incurred an NOL of $150,000 in 2020 but had taxable income of $200,000 in 2019. The company can apply the 2020 NOL to reduce its taxable income for 2019, effectively lowering the taxes it paid in 2019.

• In 2019, Company B paid taxes on $200,000 in taxable income, at a tax rate of 30%. The taxes paid in 2019 would be $60,000.
• With the NOL carryback, Company B can now apply the $150,000 NOL to offset the 2019 taxable income, reducing it to $50,000.
• As a result, the taxes owed for 2019 drop to $15,000 ($50,000 x 30%).
• The $45,000 tax refund ($60,000 - $15,000) can be claimed from the IRS.

In recent years, the CARES Act temporarily allowed businesses to carry NOLs back for up to 5 years, but this provision was repealed after 2020. Now, businesses can only carry NOLs forward, with a cap of 80% of taxable income.

How to claim loss carryforward or loss carryback on your tax return

Here are the steps to claim loss carryforward or loss carryback on your tax return:

1. Fill out your business’s tax return: Start by filing your business’s tax return for the relevant year.
2. Determine if you have an NOL: To identify if you have a NOL, check if your tax deductions exceed your income for the year. This can be calculated by completing IRS Form 1045 or other relevant forms.
3. Choose your NOL application method: Decide whether you want to carry the NOL back to offset past income or carry it forward to reduce future taxable income. For carrybacks, businesses generally use Form 1045 (for individual taxpayers) or Form 1139 (for businesses).
4. Submit the appropriate documentation: Ensure all records and documents are submitted with the tax return. This may include prior year tax filings, carryforward details, and NOL calculations.

What to bear in mind

• Record keeping: Always keep records of the NOLs and related documents for the years involved. The IRS recommends keeping these records for at least three years after the NOL carryback or carryforward has been fully used.

• IRS consultation: Since NOL rules can be complex and subject to tax law changes, it’s recommended to consult with a tax professional to ensure you’re maximizing your tax relief.

Please note the legal disclaimer for this article.