What Is a Loss Carryforward?
A loss carryforward refers to an accounting technique that applies the current year's net operating loss (NOL) to future years' net income to reduce tax liability.
For example, if a company experiences negative net operating income (NOI) in year one, but positive NOI in subsequent years, it can reduce future profits using the NOL carryforward to record some or all of the loss from the first year in the subsequent years.
This results in lower taxable income in positive NOI years, reducing the amount the company owes the government in taxes. Loss carryforward can also refer to a capital loss carryforward.
Key Takeaways
- Loss carryforwards are used to spread a current net operating loss (NOL) over subsequent years' net operating income (NOI) in order to reduce future tax liability.
- The Tax Cuts and Jobs Act (TCJA) removed the two-year carryback provision, extended the 20-year carryforward provision out indefinitely, and limited carryforwards to 80% of net income in any future year.
- Net operating losses originating in tax years beginning prior to Jan. 1, 2018, are still subject to the former carryover rules.
:max_bytes(150000):strip_icc()/Term-l-losscarry-forward_Final-7d7cf6e694dd4a84bad7267015a542d3.png "Loss Carryforward: Definition, Example, and Tax Rules (1)")
What Are the Rules for Loss Carryforwards?
Prior to the implementation of the Tax Cuts and Jobs Act (TCJA) in 2018, the Internal Revenue Service (IRS) allowed businesses to carry net operating losses (NOL) forward 20 years to net against future profits or backward two years for an immediate refund of previous taxes paid. After 20 years, any remaining losses expire and could no longer be used to reduce taxable income.
For tax years beginning Jan. 1, 2018, or later, the TCJA has removed the two-year carryback provision, except for certain farming losses, but allows for an indefinite carryforward period. However, the carryforwards are now limited to 80% of each subsequent year's net income. Losses originating in tax years beginning prior to Jan. 1, 2018, are still subject to the former tax rules and any remaining losses will still expire after 20 years.
NOL carryforwards are recorded as assets on the company's balance sheet. They offer a benefit to the company in the form of future tax liability savings. A deferred tax asset is created for the NOL carryforward, which is offset against net income in future years. The deferred tax asset account is drawn down each year, not to exceed 80% of net income in any one of the subsequent years, until the balance is exhausted.
The NOL carryforward provision relating to federal income taxes was originally introduced as part of the Revenue Act of 1918. Some states have stricter limits for state income tax on carryforwards or carrybacks.
Originally, this federal income tax provision was intended to be a short-lived benefit to companies incurring losses related to the sale of war-related items in the post-WWI era. Over the following years, the provision's duration for carryovers has been extended, decreased, omitted, and reinstated. The purpose of keeping the provision was to smooth the tax burden for companies whose primary business is cyclical in nature, but not in line with a standard tax year.
How Can Businesses Use Loss Carryforwards?
To use NOL carryforwards effectively, businesses should claim them as soon as possible. The losses are not indexed with inflation, and as a result, each year the claim effectively becomes smaller.
For example, if a business loses $100,000 in the current tax year, although it may carry the loss forward for the next 20 years, it is likely to have a larger impact the sooner it is claimed. As a result of inflation, it is most likely that $100,000 will have less buying power and less real value 20 years from now.
Example of a Loss Carryforward
Imagine a company lost $5 million one year and earned $6 million the next. The carryover limit of 80% of $6 million is $4.8 million. The full loss from the first year can be carried forward on the balance sheet to the second year as a deferred tax asset.
The loss, limited to 80% of income in the second year, can then be used in the second year as an expense on the income statement. It lowers net income, and therefore the taxable income, for that year to $1.2 million. A $200,000 deferred tax asset ($5 million - $4.8 million) will remain on the balance sheet.
How Many Years Can a Loss Be Carried Forward?
A business can carry a loss forward over 20 years, with a carryover limit of 80% of each subsequent year's net income.
How Much Loss Can You Write Off in a Loss Carryforward?
A company can write off 80% of each subsequent year's net income in a loss carryforward. In this way, if a company lost $10 million in one year and earned $12 million the following year, it can carryover $9.6 million on the balance sheet in the second year. This is then indicated as a deferred tax asset, and is represented as an expense on the income statement. The benefit is that it lowers the taxable income in the second year to $2.4 million.
What Is the Difference Between a Loss Carryforward and Carryback?
A loss carryforward allows a business to carryover a loss to the net operating income to reduce its tax liability. This loss can be carried forward over the next 20 subsequent years. By contrast, a loss carryback allows a firm to apply a loss to a previous year's tax return. This results in an immediate refund of the taxes paid in that year.
The Bottom Line
If a business reports a loss in a given year, the carryforward tax provision allows this company to apply this loss to its future net operating income over the next 20 years. This is one way that companies have the potential to significantly reduce their tax burden if they report positive net income over this time horizon.
Importantly, it is most effective to apply this loss sooner than later due to inflation impacting the purchasing power of money instead of waiting to carryforward a loss.
