Net Operating Losses

A net operating loss (NOL) occurs when a taxpayer's allowable tax deductions exceed their gross income for a given tax year, resulting in a negative taxable income figure. NOLs arise most commonly in business contexts when operating expenses, depreciation, and other deductions outpace revenue in a particular period. Under current federal tax law following the Tax Cuts and Jobs Act of 2017, NOLs generated in tax years beginning after December 31, 2017 can no longer be carried back to prior years—instead, they can only be carried forward indefinitely. However, the carryforward deduction is limited to 80% of taxable income in the carryforward year, meaning NOLs cannot entirely eliminate tax liability in most cases. Special rules applied during the COVID-19 period under the CARES Act, temporarily allowing five-year carrybacks for certain NOLs. NOL rules differ for individuals, corporations, and pass-through entities, and state tax treatment often diverges from federal rules. Properly tracking and utilizing NOL carryforwards is an important tax planning strategy that can significantly reduce future tax liabilities for businesses and individuals experiencing cyclical income fluctuations.

Under current federal tax law established by the Tax Cuts and Jobs Act of 2017, most businesses can no longer carry back net operating losses to prior tax years. NOLs generated in tax years beginning after December 31, 2017 are restricted to carryforward-only treatment, meaning they can only be applied to reduce taxable income in future years. This represents a significant departure from prior law, which allowed two-year NOL carrybacks that could generate immediate tax refunds for businesses experiencing losses. One notable exception occurred under the CARES Act of 2020, which temporarily allowed a five-year carryback for NOLs arising in tax years 2018, 2019, and 2020—providing critical liquidity relief for businesses impacted by the pandemic. Outside of this temporary provision, NOL carrybacks are generally unavailable for most post-2017 losses. Farming losses and certain insurance company losses retain limited carryback provisions. Taxpayers should consult with a qualified tax professional to determine whether any carryback opportunities apply to their specific situation and to ensure compliance with the complex NOL rules that govern their entity type and industry.

The Tax Cuts and Jobs Act of 2017 introduced an 80% taxable income limitation on the use of net operating loss carryforwards generated after December 31, 2017. Under this rule, a taxpayer cannot use NOL carryforwards to reduce their taxable income below 20% of the amount that would otherwise be taxable in a given year. This means that even a taxpayer with substantial NOL carryforward balances will still owe some federal income tax in profitable years, rather than being able to fully shelter all income as was possible under prior law. The 80% limitation applies to each year independently—remaining NOL balances continue to carry forward indefinitely without expiration for post-2017 losses. For tax planning purposes, the 80% cap affects cash flow projections and the timing of income recognition strategies, as taxpayers cannot fully offset large income years with NOL deductions. Pre-2018 NOLs that remain available are not subject to the 80% limitation and can still fully offset taxable income, but they retain the 20-year carryforward limit from prior law. Tracking the vintage and characteristics of NOL carryforwards is essential for accurate tax planning and financial reporting under ASC 740.

Net operating loss rules differ significantly between individual taxpayers and corporations, creating important distinctions that tax professionals must understand for accurate compliance and planning. For C corporations, an NOL is calculated at the entity level and generally subject to the post-2017 rules allowing indefinite carryforwards limited to 80% of taxable income per year, with no carryback for most losses. For individual taxpayers, NOLs typically arise from business activities reported on Schedule C, Schedule E, or Schedule F, and the NOL is calculated after adjusting for non-business deductions. Individuals must also contend with the excess business loss limitation introduced by the TCJA, which caps the amount of net business losses an individual can deduct in a single year, with excess amounts converted to an NOL carryforward. Pass-through entities such as partnerships and S corporations do not recognize NOLs at the entity level—losses flow through to the owners, who apply them at the individual level subject to basis, at-risk, and passive activity limitations. State income tax treatment adds another layer of complexity, as many states have their own NOL rules that do not conform to federal law. Expert accounting guidance is essential for navigating NOL planning across different entity structures.

Accurate record-keeping for net operating loss carryforwards is essential for both tax compliance and financial reporting purposes, and inadequate documentation is one of the most common NOL-related audit vulnerabilities. Businesses should maintain a detailed NOL tracking schedule that records the year each loss was generated, the original amount, the vintage classification (pre-2018 versus post-2017, as different rules apply), the amount used in each subsequent year, and the remaining carryforward balance. Tax returns and supporting workpapers for the loss year should be retained indefinitely, as NOL carryforwards can span many years and the IRS may audit the loss year even after the normal statute of limitations if the carryforward remains in use. Financial accounting records under ASC 740 must reflect deferred tax assets for NOL carryforwards, along with any valuation allowances required if it is more likely than not that the deferred tax asset will not be realized. Documentation of the basis for valuation allowance decisions should be updated annually. For acquired companies, NOL carryforwards may be subject to Section 382 limitations that restrict their annual use following ownership changes—these limitations require separate tracking. Proactive NOL record management significantly reduces risk and supports strategic tax planning across future profitable years.