As April 15 approaches, businesses are faced with a major challenge: They not only need to communicate their tax returns to the IRS, but also their previous year’s profits. Small businesses, self-employed individuals, and freelancers need to take the cash inflow and outflow principle into account when calculating their profit. But what exactly does this mean? This guide will help you through this...
Not every year goes as expected and sometimes it could be the case that companies don’t make as much profit as they did in previous years. When expenditure starts to exceed revenue, you will then find yourself in a loss position. It’s not all doom and gloom though, as you may be able to use this loss to offset the tax due on profits either in past or future years meaning that your business can minimize its tax liability. The reason for this is that businesses are allowed some tax relief when they aren’t making much money.
In order to work out whether this is something that could help you and your business, you first need to know the difference between loss carryforward and loss carryback.
The difference between loss carryback and loss carryforward
The former is a provision that allows an individual or business to use a net operating loss (NOL) in one year in order to offset a profit in previous years. The latter follows the same principle but the tax loss is carried over to an upcoming year, rather than being used in reference to a past one.
Losses used for these provisions must be net operating losses - not losses on investments.
What is a net operating loss?
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.
Who can use loss carrybacks and loss carryforwards
Businesses, as well as individual taxpayers, can use these two provisions against a net operating loss as well as for capital losses in excess of capital gains and certain gains from the sale or exchange of business stock.
Some businesses are purchased because of the fact that they have an NOL. The Internal Revenue Service (IRS) is trying to prevent this from happening by placing a restriction on the usage of an acquired NOL. The Section 382 Limitation states that the restriction is in force when there is at least 50% ownership change in the business that has an NOL. The new owner can only use a portion of the NOL in each successive year that is based on the long-term, tax-exempt bond rate multiplied by the acquired entity’s stock.
How to claim a loss carryforward or loss carryback
Taxes can be confusing at the best of times, so in order to make it as easy as possible, we’ve come up with some steps showing how to claim both of these provisions:
- Firstly, fill out the tax return for your business type.
- Work out whether you have a net operating loss. If your tax deductions are greater than your income, it could be the case that you do have an NOL. It isn’t too difficult to calculate if you follow the instructions on Form 1045.
- This is when you have to decide if you plan to carry back the tax loss to a previous year or forward to a future year.
- If your net loss is more than your profit in one year, you can carry over the unused NOL to the next carryforward year or a previous year.
There are, however, many rules and exceptions for claiming a tax loss carryforward, which is why hiring a professional could be a good idea.
The IRS also recommends you to keep all your records to facilitate the task of completing tax returns:
"You should keep records for any tax year that generates an NOL for 3 years after you have used the carry back/carryforward or 3 years after the carryforward expires."
Click here for important legal disclaimers.