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NOL Tax Loss Carryforward

Using prior losses to lower future taxes

What is an NOL/Tax Loss Carryforward?

A net operating loss (NOL) or tax loss carryforward is a tax provision that allows firms to carry forward losses from prior years to offset future profits, and, therefore, lower future income taxes. The way a tax loss carryforward works is that a schedule is generated to track all cumulative losses, which are then applied in future years to reduce profits until the balance in the TLCF is zero. An NOL carryforward schedule is commonly used in financial modeling.

Tax Loss Carryforward theme

Key Highlights

  • A net operating loss (NOL) or tax loss carryforward is a tax provision that allows firms to carry forward losses from prior years to offset future profits, and, therefore, lower future income taxes.
  • Tax loss carryforwards exist so that the total lifetime taxes for a firm will, in theory, be the same no matter how their profits and losses are spread out.
  • Typically, when an acquisition is structured as a stock acquisition, the acquiring company obtains the ability to use the target’s NOLs going forward. However, there may be limits placed on the usage of these acquired NOLs. For example, in the United States, the usage of acquired NOLs is governed by Internal Revenue Code (IRC) Section 382.

What is the Purpose of an NOL/Tax Loss Carryforward?

Tax loss carryforwards exist so that the total lifetime taxes for a firm will, in theory, be the same no matter how their profits and losses are spread out.

Example if firms could NOT carry forward losses

A company that had a loss of $10 million in 2018 and a profit of $10 million in 2019 with a 30% tax rate would pay zero tax in 2018 and $3 million in 2019. Its total profit before tax in 2018 and 2019 combined was zero, yet it paid $3 million in taxes.

Compare that to a different company that also had $0 of profit in 2018 and $0 of profit in 2019. This company would pay zero taxes and had a total pre-tax profit of $0.

So why would the first company pay $3 million in taxes while the second company paid none? The first company is much worse off due to the distribution and timing of its profits.

To address this issue, tax loss carryforwards were created.

Building a Tax Loss Carryforward Schedule

The easiest way to keep track of a TLCF schedule is to create a model in Excel. In the screenshot below, you can see how a financial analyst creates the schedule.

Schedule to carry forward losses

Steps to create a tax loss carryforward schedule in Excel:

  1. Calculate the firm’s Earnings Before Tax (EBT) for each year
  2. Create a line that’s the opening balance of carryforward losses
  3. Create a line that’s equal to the current period loss, if any
  4. Create a subtotal line
  5. Create a line to calculate the loss used in the period with a formula stating that “if the current period has taxable income, reduce it by the lesser of the taxable income in the period and the remaining balance in the TLCF.
  6. Create a closing balance line equal to the subtotal less any loss used in the period
  7. Next period’s opening balance equals the last period’s closing balance

Example tax loss carryforward

Below is a screenshot of a tax loss carryforward schedule built in Excel. This is taken from CFI’s e-commerce/startup financial modeling course, in which a company has the ability to carry forward losses due to the significant losses expected to be incurred by the business in its first few years of operation.

Tax Loss Carryforward - NOL Carryforward Example in Excel

The best way to learn how to build a TLCF schedule is by practicing. By using the example provided, you can see how it was designed and test yourself to create your own in Excel. If you want a completed example to work with, check out CFI’s financial modeling templates library of completed models from beginner to advanced.

Treatment of NOLs in an Acquisition

Typically, when an acquisition is structured as a stock acquisition, the acquiring company obtains the ability to use the target’s NOLs going forward. However, there may be limits placed on the usage of these acquired NOLs. For example, in the United States, the usage of acquired NOLs is governed by Internal Revenue Code (IRC) Section 382.

Basics of IRC 382

There are two main components of Section 382 — limitation and ownership change. An ownership change occurs when one or more 5% shareholders increase their ownership, in aggregate, by more than 50% over a testing period. Obviously, an acquisition will trigger a change in ownership.

Limitations of IRC 382

After the acquisition, the acquiring company may deduct the acquired NOLs against its taxable income after calculating the Section 382 base limitation. The formula used in calculating the base limitation amount is:

Fair Market Value of the Target Corporation Stock x Federal Long-Term Tax Exempt Rate = Base Limitation Amount

When calculating the base limitation amount, the fair market value depends on potential adjustments as set forth in Internal Revenue Service (IRS) regulations. The IRS publishes the federal long-term tax-exempt rate monthly.

The base limitation formula drastically limits the usage of acquired NOLs.

Learn more by reading a helpful guide on Internal Revenue Code 382 from Cornell Law School.

Always consult a professional tax advisor before filing any tax forms.

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