Posted by Fletcher Accounting and Tax Service Inc.

Breaking Down Net Operating Loss

Breaking Down Net Operating Loss

In relation to income tax, once a company’s eligible expenses surpass its taxable income during the tax period it becomes an NOL or the Net Operating Loss. Most companies usually utilize their NOL to offset in their tax obligations in one of the following tax years, with the help of Loss carry forward, a tax rule provided by the IRS.

Essential Points

  • In the event that the company’s expenses surpass its taxable income, the result is NOL (Net Operating Loss).
  • NOL helps companies minimize their taxable income in the coming years.
  • Starting with the tax year of 2018, there are important amendments in NOL policies that were carried out by the Tax Cuts and Jobs Act.
  • There will be a limit on the taxable income an NOL can carry forward which is 80%, however, the number of years a loss carry-forward provision can be utilized is limitless until the loss is returned.
  • A company’s carry forward will be restricted if it obtains another company with an outstanding NOL as indicated in section 382.

How a Net Operating Loss (NOL) Is Used

In order to minimize the company’s future tax payables, NOL will be used to offset taxable income incurred in the preceding years through carryforward. The underlying reason for this tax rule is to give a certain sort of tax assistance to a company whenever it incurred a loss in a certain tax period. Most of the company’s business profits are periodic in nature and do not conform to the regular tax year and this was being acknowledged by the IRS.

Let's take a farming business as an example. Suppose that in the first year, it has a remarkable profit, in the second year it bears an NOL while the third year is a fruitful one. With the help of the rule in loss carryforward, it lessens the tax weight by allowing the NOL incurred in the second year to be deducted in the third year’s tax payables.

Requirements for a Net Operating Loss Carryforward

In 2018, Tax Cuts and Jobs Act (TCJA) made a huge change in their provision. Before the said changes, Internal Revenue Service (IRS) set 20 years future income as  limit to the carrying forward of businesses NOL, furthermore, for urgent refund of the previous taxes that the taxpayer already paid, it can be carried backward as it allows a two years limit. Carry back method is said to be the most advantageous option since the current tax savings worth more compared with the future tax savings. Outstanding losses after 20 years will be expired and will not be eligible to deduct taxable income.

The Tax Cuts and Jobs Act has abolished the 2 years carryback rule and it will effect starting with the tax year 2018, which started on January 01 and the years after. In every rule, there is an exemption, and certain farming losses are an exception to the rule. Moreover, it was replaced by a limitless carryforward period. On the other hand, claims for carryforward for each succeeding year’s net income will be limited to 80%. In case a business obtains an NOL repeatedly, the first NOL incurred must be totally drawn down before reducing the additional NOL. Losses incurred earlier than January 1, 2018 (tax season) are still covered with the previous tax provision which implies that any outstanding losses will be subjected to the expiration of 20 years.

If we talk about recording an NOL carryforward to the company’s general ledger, it becomes an asset. Carrying forwards of NOL provides advantage to the company through subsequent tax liability savings. Be informed that a deferred tax asset is an offset over net income in coming years, and this is formulated for the NOL carryforward. Each year the deferred tax asset account will be reduced with a maximum of 80% of the total net income in one of succeeding years as long as the remaining will be totally worn-out.

Example of a Net Operating Loss Carryforward

Assume that in a year, a company incur a total of $5 million of NOL and acquire a taxable income of 6 million in the following year. If we calculate the maximum limit of the carryforward which is 80% of $6 million, we will get 4.6 million. In the second year, the balance sheet will show that the loss from the first year was carried forward through a deferred tax asset. Furthermore, 80 % (max) of the income in the second year will be considered as loss and can be utilized as an expense that will be recorded in the income statement of the second year. Thus, this will minimize the net income in the second year ($6 million - $4.8 million), as a result, the taxable income for the second year will only equal to $ 1.2 million. Take note that in the third year a deferred tax asset amounting to $200,000 will be carried out and will still remain on the balance sheet.

Fletcher Accounting and Tax Service Inc.
Contact This Member