Net Operating Loss (NOL) Deduction and Tax Planning

Net Operating Loss (NOL) Deduction and Tax Planning

Running a business often involves unexpected challenges, including financial losses. Fortunately, federal tax law offers a way to offset these losses against future taxable income through the Net Operating Loss (NOL) deduction. However, to benefit from this deduction, it's crucial to understand the key conditions and limitations involved.

Eligibility for the NOL Deduction

The NOL deduction is designed to address tax imbalances between businesses with stable income and those with fluctuating income. It allows the latter to average their income and losses over several years, thus reducing their tax liability.

To qualify for an NOL deduction, the deductions for the tax year must exceed the income. Typically, an NOL can arise in the following situations:

• Business Losses: Losses reported on Schedule C, Schedule F, or Schedule K-1 from a partnership or S-corporation.

• Casualty and Disaster Losses: Losses resulting from federally declared disasters.

• Rental Property Losses: Losses reported on Schedule E related to rental properties.

However, the following items are generally excluded from NOL calculations:

• Capital losses exceeding capital gains.

• Gains from the sale or exchange of qualified small business stock.

• Non-business deductions exceeding non-business income.

• The NOL deduction itself.

• The Qualified Business Income (QBI) deduction under Section 199A.

Individual proprietors and C corporations can claim the NOL deduction, but partnerships and S corporations typically cannot. However, partners and shareholders can calculate personal NOL based on their share of business income and deductions.

Changes Before and After the Tax Cuts and Jobs Act (TCJA)

Before TCJA:

• Carryforward: Unused NOL could be carried forward for up to 20 years. This allowed businesses to reduce future taxable income and, consequently, future tax liabilities. For example, a business with a $1,000,000 loss in one year could apply that loss against taxable income in the next 20 years.

• 100% Deduction: The NOL could be applied to 100% of taxable income, effectively allowing businesses to eliminate their tax liability in profitable years following a loss.

After TCJA:

• Elimination of Carryback: The TCJA eliminated the carryback provision for most taxpayers, meaning NOL can no longer be applied to past tax years. However, there are exceptions, such as for certain farming losses.

• Unlimited Carryforward: The TCJA removed the 20-year limit, allowing NOL to be carried forward indefinitely. This provides greater flexibility for future tax planning.

• 80% Limitation: NOL deductions are now limited to 80% of taxable income. For example, if a business has a $1,000,000 NOL and $1,000,000 in taxable income in the next year, only $800,000 of that income can be offset by the NOL, leaving $200,000 subject to tax.

Excess Business Loss Limitation

The TCJA introduced the "excess business loss" limitation, effective from 2021. This limitation applies at the partner or shareholder level in partnerships or S corporations after applying the basis, at-risk, and passive activity loss limitations. Non-corporate taxpayers can only offset business losses against business income or gains, and these losses cannot exceed a certain threshold adjusted for inflation. For 2023, the threshold is $289,000 ($578,000 for joint filers), increasing to $305,000 ($610,000 for joint filers) in 2024. Any remaining loss is carried forward as NOL, subject to the 80% income limitation, which reduces its tax value.

 Keywords

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