What is Net Operating Loss (NOL)?
A net operating loss (NOL) is when a company’s allowable deductions exceed the taxable income within a tax period. Because the company’s deductibles are greater than its actual income, the Internal Revenue Service (IRS) allows the company to use the loss and carry it forward in the future to set off future profits. It helps reduce the tax liability of the business.
Common Reasons for Net Operating Loss
One of the most common reasons for net operating loss is when companies are in their early start-up years. In the early stage, start-ups are often not profitable. Another common cause of NOL is losses incurred by a business in its operations. It is 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 specific period;
- The company can get a refund for previously paid taxes; and
- The company can use its business losses to lower future taxable income.
The benefit of carrying an NOL carryback is to reduce a company’s 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, it can sometimes carry the amount back for three years under special circumstances, such as losses due to theft. It is done through 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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