A net operating loss is a loss taken in a period where a company’s allowable tax deductions amount to being greater than its taxable income. The company’s NOL can generally be used to recover past tax payments or be used to reduce future tax payments by making a company unprofitable for tax purposes. Here is an example to put things into perspective:
Company X has a taxable income of $1,000,000 and tax deductions of $1,300,000. This means its NOL is $1,000,000 - $1,300,000 = -$300,000. Since there was no income to tax, Company X won’t pay any taxes that year.
But what happens if Company X makes a lot of money the next year? If $250,000 of taxable income is made and the company’s tax rate is 40%, then $100,000 would need to be paid in taxes ($250,000 x 40% = $100,000). The NOL incurred last year can be applied to this year’s taxes, which will reduce it significantly, maybe even to zero.
It would also be possible for Company X to carry the NOL back and use it for previous years, rather than future years.
The great thing about NOLs is that they provide relief to your company if needed. If your company isn’t doing well, the net operating loss is there to indicate that your business is unprofitable for tax purposes. Some companies are actually bought only because of their NOLs.
The laws on NOLs are different, depending on which state you’re in, but the general rule is that an NOL from the last few years can be applied up to 20 years in the future. If it isn’t used in this timeframe, it will expire. Each case is different so it’s best to get in touch with the IRS or hire a tax accountant to make sure you know what’s right for your business.
If a business creates several NOLs in more than one year, they have to be noted in the order they were created to minimize the risk of one of them not being used and then expiring.