What Is a Tax Loss Carry Forward?
A tax loss carry forward, also referred to as a net operating loss carryover, allows some businesses and individuals to carry forward their losses to offset profit in future years. This carry forward is a way for the government to help businesses weather the tough years.
As a small business owner, you may dread handling your business taxes each year. While this can be a confusing topic, it’s also incredibly important to understand the ins and outs—or have someone on your team who does—so you can be sure your business owes the least amount of taxes possible. After all, fewer taxes means more money to invest back into your business. And understanding how a tax loss carry forward works can help offset your tax bill significantly.
How do tax loss carry forwards work? Many businesses—especially in their early years—will have years where they aren’t profitable. If at the end of the year, a business has lost money, that will be considered a net operating loss. That net operating loss can then be carried forward to future years to offset the amount of taxes you’ll need to pay when your business becomes profitable. You can think of it as averaging out your tax liability over a number of years.
For example, a business may experience profits and pay a large tax bill in the first year, experience a loss in the second year, and then large profits again in the third year. By using a tax loss carry forward, the business is able to use the losses from the second year to reduce the amount of taxes it has to pay in the third year.
A famous example of this comes from Donald Trump, who was able to avoid paying income taxes for 18 years. He did this by carrying forward his $916 million net operating loss in 1995 to offset his income in future years. While this is an extraordinary example, thousands of businesses and individuals use tax loss carry forwards to reduce their tax bill each year.
How Do Tax Loss Carry Forwards Work?
Tax loss carry forwards can be a complicated topic. Making this even more complicated are the recent changes from the Tax Cuts and Jobs Act (TCJA). The TCJA changed a lot related to small business taxes, including the way businesses were able to use business losses to offset tax liability.
Net operating loss rules for losses prior to January 1, 2018:
- Losses could be carried back for two years or forward for 20 years.
- Deduction is taken on up to 100% of taxable income.
Net operating loss rules for losses in tax years starting on or after January 1, 2018:
- Losses can be carried forward indefinitely.
- Deduction is taken on up to 80% of taxable income.
Prior to the TCJA changes, businesses were able to offset 100% of their taxable income by choosing whether to carry their losses forward for 20 years or backward for two years. Because there were no limits, a net loss of $100 in one year could completely offset taxable income of $100 the next. Even more helpful, if a company chose to carry the loss backward, it would receive a tax refund for taxes paid in the prior year. That could provide cash relief for businesses during the years they were struggling.
In tax years starting January 1, 2018, and later, the TCJA changed the way businesses were able to utilize their net operating losses. The option to carry the loss backward was eliminated, except for certain farming losses. Instead, the 20-year carry forward limit was eliminated and businesses are now able to carry the losses forward indefinitely. But there are some additional limitations and restrictions, including the taxable income limitation, that businesses now need to use to calculate their net operating loss.
What Type of Businesses Can Use a Tax Loss Carry Forward?
A tax loss carry forward is treated differently depending on your business structure. Corporations are the only business structure that are allowed to use a net operating loss carry forward. If a corporation experiences a net operating loss, it can be used to offset business income in future years.
That doesn’t mean that businesses other than corporations miss out on this benefit. They just use it in a different way. Pass-through entities—partnerships, LLCs, and S-corporations—are not allowed to use a tax loss carry forward at the business level, per the IRS. This is because pass-through entities don’t file separate business taxes—everything is passed through to the owners’ personal tax returns. Thus, if your business has a tax loss, it will be passed through to your personal tax return to offset your personal income in the current and future years, with some limitations.
Tax Loss Carry Forward Limitations
With the TCJA, two limitations to the tax loss carry forward rules were introduced.
Prior to the TCJA, businesses were able to use a tax loss carry forward to offset up to 100% of their taxable income for the year. That meant if a business had $50,000 of losses in year one and $50,000 of taxable income in year two, the $50,000 tax loss carry forward rule could be used to pay no taxable income in year two.
With the changes to the tax law, tax loss carry forwards now can’t exceed 80% of taxable income. For example, if a corporation had a loss of $95,000 in their first year to be carried forward and has taxable income of $100,000 in their second year, the maximum allowable tax loss carry forward that the business can take in year two is $80,000 (80% of $100,000 taxable income). The remaining $15,000 of the net operating loss from year one that wasn’t used can be carried forward to be used in future years.
Excess Business Loss Limitation
Pass-through entities like LLCs, partnerships, or S-corporations allow business owners to use net operating losses to offset personal income on their personal tax return. But the loss that you can take comes with additional annual limitations.
The business losses that a non-business taxpayer can claim are limited to $255,000 for single filers and $510,000 for people who are married and filing jointly. If you have business losses that exceed that limit, they can be carried forward to future years. For example, if your business is an LLC and the losses that are passed through to you to offset your personal income are $300,000, you’ll only be able to use $255,000 of the losses to offset income in the current year. The remaining $45,000 will need to be carried forward to use in a future year.
Tax Loss Carry Forward Example
The difference between tax loss carry forwards for a corporation and an individual can be confusing, but the rules for taking advantage of this benefit become much clearer with an example.
Calculating a Corporate Tax Loss Carry Forward
Let’s say your business is a corporation that has $500,000 in income and $800,000 in allowable deductions—meaning your net operating loss for the year is $300,000. Because of the tax loss carry forward rule, this loss can be used to offset your profit in future years.
The next year business is going really well. It has $700,000 in income and $400,000 in allowable deductions, leaving your business with taxable income of $300,000. Your tax loss carry forward is going to be put to use to offset your tax liability. Because of the 80% limit, you’ll only be able to use $240,000 of your previous $300,000 net operating loss to offset your profits in the current year. The remaining $60,000 can continue to be carried forward to offset your business’s taxable income in the next year.
Calculating Tax Loss Carry Forward as a Pass-Through Entity
Now let’s say your business isn’t structured as a corporation, but as an LLC. The LLC can’t use a tax loss carry forward to offset income, but the benefit can be passed through and used on your personal tax return.
If your business has $500,000 in income and $800,000 in allowable deductions, your business has a loss of $300,000. But only a maximum of $255,000 of that loss can be claimed to offset your personal income in the current year. The remaining $45,000 can be carried forward to offset your personal income in the next year.
How to Claim a Tax Loss Carry Forward
Determining whether you have a net operating loss to be carried forward is a complicated process that is best to have your business accountant help with. These are the basic steps involved in calculating and claiming your tax loss carry forward:
- Complete the correct tax return for your business type.
- Determine whether you have a net operating loss. You may have a net operating loss if your deductions are greater than your income. If your business is not a corporation, there are some deductions that aren’t allowable when calculating this number, as explained by Worksheet 1 from IRS publication 536.
- Calculate the amount of your unused net operating loss. You’ll use this amount to calculate your allowable deduction for your next profitable year. You can continue carrying your net operating loss forward to future tax years until it has been used completely.
- Keep your tax records. In any year that you have a net operating loss you’ll need to hold onto your tax records for three years. Those three years start from the year which you had the loss or the last year which you carry forward the loss, whichever is later.
Tax Loss Carry Forward and an Ownership Change
A net operating loss is a valuable asset for a company to use in the future—it can be used to significantly reduce the future tax liability for a business. But think twice before you consider buying a business that has a large net operating loss. The IRS has placed a significant restriction on the use of a net operating loss when more than 50% of the business has changed ownership.
These limitations, detailed in IRS section 382, limit the annual net operating loss deduction to be the value of the business at the time of the sale multiplied by the long-term tax-exempt rate (as set by the IRS). In other words, if a business was valued at $1 million before the acquisition and the long-term tax-exempt rate was 3%, the maximum allowable net operating loss deduction you can take per year is limited to $30,000. If the total net operating loss exceeds this amount, you can continue to carry it forward until the full amount has been deducted.
Tax Loss Carry Forward: Final Thoughts
Not every year in your business’s life will be profitable, but carrying forward your tax losses can be a valuable tool to help your business recover from the down years. While you probably want a tax professional to help you navigate the ins and outs of maximizing your tax loss carry forward, understanding the basics can help you when making decisions about the options available to you.