Tax Reform Toolkit: Understanding Changes to the Net Operating Loss Deduction

Before the Tax Cuts and Jobs Act (TCJA) went into effect, a business’s net operating losses (NOLs) could generally be carried back two years and carried forward 20 years to offset taxable income.

Tax reform, however, repealed the two-year carryback allowance and other special carryback provisions for losses arising in tax years beginning after Dec. 31, 2017.

The TCJA also placed limits on the use of NOLs. Starting in tax year 2018, businesses may no longer use NOLs to offset all of their taxable income in subsequent years.

The NOL deduction is now limited to 80% of taxable income (which is determined without regard to the new 20% pass-thru deduction). In other words, business owners may no longer use NOLs to reduce tax liability to zero.

Any NOL carryforwards must be applied in the first subsequent tax year in which the business has positive taxable income and may now be carried forward indefinitely rather than limited to a 20-year period.

Example

Consider Joe, the owner of a business that posts a net loss of $100,000 in 2018. The business fares better in 2019, making a $100,000 profit before taxes. He does not have historical NOLs on the books to use in future years.

Under prior law, Joe would have been able to deduct the 2018 loss in 2019, fully eliminating the business’s tax liability.

But now, Joe may only deduct $80,000 (80% of $100,000). Rather than erasing taxes owed on the $100,000 profit in 2019, the NOL deduction reduces taxable income to $100,000 minus $80,000, or $20,000. The $20,000 NOL left over then essentially goes on the ledger as a “tax asset,” an asset that will increase after-tax income in the future.

In 2020, Joe’s business makes $150,000. Because it is a profitable year, he is required to apply his unused NOLs to the largest extent possible. In Joe’s case, the $20,000 NOL carryforward reduces taxable income to $130,000.

While a business should theoretically be able to use the aggregate value of net operating losses to offset tax liability in the future, some taxpayers and types of businesses may find that this is not the case.

Capital-intensive startups, for instance, could post losses for years before finally making a profit. If the annual losses are large and—even in good times—the margins are small, one can imagine a situation in which the benefits are never fully realized. New active loss limitation rules enacted in the TCJA also erode the benefit of NOLs to upper-income taxpayers.

As the rules are applied here are done so in a simple example, you should discuss your personal situation with a tax professional. The new NOL deduction interacts with other areas of the tax code, which could make the picture messier and increase (or decrease) taxes owed.

DISCLAIMER

This article is for informational purposes only. It should not be considered tax advice. Before making any tax decisions, work with a tax professional. For more detail, please see the full disclaimer.