Since it’s been in the news lately, we wanted to give an overview of what an NOL carryover is and how it works.
What is an NOL?
NOL stands for net operating loss, and it exists when a business has a net loss in a given year. The NOL carryover provision allows taxpayers to use business net losses in one year to offset business net income in another year. This provision exists for two main reasons:
- First, the fairness of an annual reporting period. The Senate Report to the Revenue Act of 1932 (try saying that three times fast) stated: “[NOLs are an] essential protection against excessive hardships inherent in a tax based upon an arbitrary annual accounting period.” Basically, we decided to use the calendar year for tax filings to make things easier, and just because you take a loss in one year doesn’t mean that you shouldn’t be able to offset it against future gains if they occur a year or more in the future.
- Second, businesses, especially new businesses, are subject to fluctuations in earnings. The allowance of NOL carryovers help aid existing business while also encouraging new ventures.
Is this a new thing?
Not so much. The NOL carryover provision began in 1918 (along with the Curse of the Bambino). The idea was that, for a country just coming out of WWI, there would be business losses as a result of the war and taxpayers needed relief. The original provision allowed businesses to take a current-year loss and carry it back and/or forward one year in either direction. In the years following, the carryover provision was extended via various subsequent tax acts, the specifics of the provision changing with the times. Almost one hundred years later, the NOL is alive and well.
Let’s have an example.
If you start a business and lose $100 on December 31st of year 1, then 2 days later on January 2nd you make $100, you shouldn’t have to pay tax just because the two days separating your cost and your revenue happen to cross over an arbitrarily chosen calendar year-end. The IRS doesn’t refund you any taxes in loss years, so the NOL lets you use it to offset years with income. In this example, you can use the $100 loss from year 1 to offset the $100 gain in year 2, leaving no taxable income in year 2.
Can I only carry losses forward?
Nope. NOLs must first be carried back two years, with the remainder carried forward for up to 20 years. However, an election can be made to waive the carryback and carry the entire loss forward. But be careful! As a recent ruling confirmed, if you forget to make the election to waive your carryback but still try to carryforward all of your losses, the IRS can assume you carried-back first, and will only allow a carryforward net of what your carryback would have been.
The NOL carryover provision is a tax rule that can limit the volatility of an annual accounting period and help stimulate new business by allowing taxpayers to carryover losses from one accounting period and use them to offset income in another period. If you have any questions about how an NOL might impact you or your business, give us a shout and we can go through the specifics of your situation.