Article: Maximizing the Tax Advantages of a Net Operating Loss

March 1999

Maximizing the tax benefits of a net operating loss

One year's loss can reduce other years' taxes, if you plan properly

As a sole proprietor, partner or S corporation shareholder, business gains and losses directly affect your personal income tax liability. In an unprofitable year, you may find some small comfort in the belief that, while you lost money, you can at least deduct your net operating loss on your personal return.

Be careful. Merely having negative tax-able income will not automatically create a net operating loss (NOL) for tax purposes. Calculating an NOL on your personal tax return, and determining a strategy for treating it, is essential to turning your losses into "gains."

Generally, you can take advantage of an NOL through:

a business "casualty loss" (a loss due to theft or to property damage from a sudden, unexpected or unusual identifiable event);
deductible business expenses; and, most common,
net losses from a trade or business.

Once you determine your negative taxable income, you can calculate the actual NOL by adding back (as positive amounts) three items to your negative taxable income:

personal and dependency exemptions;
NOL carry-backs and carry-forwards generated from other years; and
the excess of non-business deductions over non-business income.

If the result is still negative, you can carry back or forward that amount to other years.

In calculating the NOL, break down all income and deductions into business and non-business components. That can be a complicated process when income from one source has both business and non-business components. For example, income from a Schedule K-1 (showing a partner’s share of partnership income) may include business portions, such as rental income, and non-business portions, such as interest income derived from the investment.

You also must break down capital gains and losses into those derived from business sources and those derived from non-business sources. To arrive at your NOL, you must add back (as a negative amount) to your taxable income the excess of non-business capital losses over non-business capital gains.

Waiving the carry-back option. You must carry back your NOL and then carry forward any unused portion, unless you make an irrevocable election to waive the carry-back period. That election will not extend your carry-forward period. You must decide whether to waive the carry-back period by the time you file your tax return for the year in which the loss occurred. Before the Taxpayer Relief Act of 1997, you could carry back losses up to three years and carry forward losses up to 15 years. The 1997 legislation, which applies to calendar years beginning in 1998, allows a carry-back period of only two years but extends the carry-forward period to 20 years. The law still allows a three-year carry-back period if you have a casualty or theft loss so you can receive tax refunds as soon as possible.

If you choose not to waive the carry-back period, use as much of the NOL as possible in the earliest carry-back year. You can use any remaining portion in the second carry-back year. Any unused portion of the NOL must carry forward to the next available year. Use as much of the NOL as possible for each subsequent year. If you do not completely use the NOL in the 20th year of the carry-forward period, you will not be able to use any remainder in the future.

To waive or not to waive. Weigh the costs and benefits of waiving the carry-back period. Compare your marginal tax rates – the tax rate of the last dollar of income – in the previous two years with your expected marginal tax rates in future years. Your expected income level, any new legislation changing the tax rates, and whether you will be paying Alternative Minimum Tax can influence future marginal tax rates.

For example, if your marginal tax rate was 15% the previous two years, but you expect to become very profitable next year, your increased income might put you in the highest bracket. In this situation, it would be more advantageous to waive the carry-back period and carry forward the NOL to years in which you can use it to reduce income that otherwise would be taxed at the highest rate.

Assess your cash needs before you commit to a waiver. Using the NOL in previous years allows you to amend those tax returns and receive a refund quickly (provided you paid tax in the year to which you carry back the loss). If you are not profitable in the next few years, you may have to wait to receive the benefits of your NOL. Measure the time value of money with your current and future cash needs when determining whether to waive the carry-back period.

Determine which option would be most advantageous for your tax planning and financial needs. Although you may generate a net operating loss in years of economic hardship, careful tax planning can mitigate the effects of your loss.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.