The economy has picked up in many sectors. But a business can still find that its operating expenses and other deductions for a particular year exceed its income — otherwise known as incurring a net operating loss (NOL).
In such cases, companies (or their owners) may be able to snatch some tax relief from this revenue defeat. Under the Internal Revenue Code, a corporation or individual may deduct an NOL from its income. But, to do so, you must carefully follow the rules.
Generally, you take an NOL deduction in one of three ways:
1. Claiming the loss in previous years, called a “carryback,” which creates a refund,
2. Claiming a “carryforward,” which lowers your future liability, or
3. Doing a little bit of both.
Typically, a corporation or individual may carry back an NOL to the two years before the year it incurred the loss. But the carryback period may be increased to three years if a casualty or theft causes the NOL, or if you have a qualified small business and the loss is in a presidentially declared disaster area. The carry forward period is a maximum of 20 years.
You must first carry back losses to the earliest tax year for which you qualify, depending on which carryback period applies. This can produce an immediate refund of taxes paid in the carryback years. From there, you may carry forward any remaining losses year by year up to the 20-year maximum. You may, however, elect to forgo the carryback period and instead carry forward a loss if you believe doing so will provide a greater tax benefit. But this is rarely a simple decision. You’ll need to compare your marginal tax rates — that is, the tax rate of the last income dollar in the previous two years — with your expected marginal tax rates in future years.
For example, say your marginal tax rate was relatively low over the last two years, but you expect big profits next year. In this case, your increased income might put you in a higher marginal tax bracket. So you’d be smarter to waive the carryback period and carry forward the NOL to years in which you can use it to reduce income that otherwise would be taxed at the higher rate.
Let’s say your C corporation suffers an $80,000 NOL in the 2014 tax year. You could first carry back the loss to 2012. If your net income that year was $9,000, you could use $9,000 of the NOL to offset this net income and receive a refund for the tax you’d previously paid on it. That would then leave you with a $71,000 NOL to apply toward the 2013 tax year. You could then use any portion of the NOL remaining as a carryforward against future tax years — up to the entire $80,000 loss or until you hit the 20-year ceiling, whichever arrives first.
One tricky aspect of navigating the NOL rules is the impact of the alternative minimum tax (AMT). Many business owners wonder whether they can offset AMT liability with NOLs just as they can offset regular tax liability.
The answer is “yes” — you can deduct your AMT NOLs from your AMT income under the same rules as for regular losses. The excess of deductions allowed over the income recognized for AMT purposes is calculated the same way as for regular NOLs. But beware that different rules for deductions, exclusions and preferences apply to the AMT.
Because the AMT is calculated differently, the AMT NOL may be less than the regular tax NOL. And bear in mind that, if you opt to forgo a carryback period for regular tax purposes, you’ve automatically done so for AMT purposes as well. Conversely, if you use a carryback period for regular tax purposes, you must also use it for the AMT.
NOLs don’t happen only when the economy is bad. They’re common among startups and also can occur when an established company is trying to take advantage of a hot market and investing heavily in marketing and new products or services. If the income from those efforts doesn’t immediately materialize, an NOL may result.
Whatever the cause of an NOL, the rules for claiming one can get complicated quickly. Work with Holbrook & Manter, CPAs to make it through the process successfully. Contact us today