A net operating loss (NOL) for income tax purposes is when a company’s allowable deductions exceed the taxable income in a tax period. When a company’s deductibles are greater than its actual income, the Internal Revenue Service (IRS) allows the company to use the loss to reduce previous years’ taxes or to carry it forward to offset future years’ profits. It is a benefit that helps reduce the tax liability of the business.
Common Reasons for Net Operating Loss
One of the most common periods for incurring net operating losses occurs when companies are in their start-up phase. Such companies often are spending more money than they are taking in, in order to generate future sales or income. Also, NOLs are commonly seen in businesses that are cyclical in nature.
An example is a mining business, where they may generate large profits in one period, incur an NOL in the next, but make back the profit again in the following period. In this case, they can carry forward the second year NOL to offset taxes in the third year.
When companies report an NOL, three common things can happen:
The company does not owe any taxes for the current period;
The company can get a refund for previously paid taxes; and
The company can carry forward its business losses to lower future taxable income.
The benefit of carrying an NOL carryback is to get a refund on a company’s previous years’ tax liability. The year that the NOL occurs will be identified as the NOL year. From that point in time, the company can carry the amount back to the previous two years.
However, companies can carry the amount back for three years under special circumstances, such as losses due to theft. It is done by filing an amended return (using IRS Form 1040x).
In case the company does not want to carry the NOL back or cannot due to prior years NOLs, it can choose to carry it forward and apply them to future taxable income for up to a 20-year period. For an NOL carryforward, the company generates a schedule to track all its cumulative losses, which are used to reduce profits in future years until the balance in the NOL carryforward is zero.
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