Net operating losses – known as NOLs in the tax professional world – are tax attributes generated when losses allocated from business activities exceed a taxpayer’s income for the year. While common sense might tell you that one generally wouldn’t want to be in a net operating loss position, as that would indicate you are losing money rather than making it, the tax benefits of NOLs can be quite significant.
For many years the rules associated with net operating losses allowed taxpayers to choose how to apply their net operating losses against taxable income – taxpayers could carry an NOL forward to future tax years, offsetting future income until the NOL is fully absorbed, for a period of up to twenty years. Alternatively, taxpayers could choose to carry an NOL back to the most recent five (depending on the year and the nature of the loss this could be two or three years, not five) previous tax years for a refund of taxes already paid. This changed with the passing of the Tax Cuts and Jobs Act of 2017, which repealed the carryback option but still allowed for the carryforward.
Fast forward to 2020 (sorry, I know you’d probably rather be in good old 2017) and the passing of the CARES Act. Suddenly, carrybacks are back on the table for NOLs generated in 2018, 2019, and 2020, and many struggling taxpayers are jumping at the opportunity for a carryback and potentially very sizable refund. Before choosing to carryback an NOL there are a number of considerations that should be made.
The first item to consider is how large the NOL is, and how much of a refund could be generated by choosing the carryback route. If the potential refund is only a few thousand dollars, it is probably not worth it. The forms required to file an NOL carryback are highly complex, and are definitely not a do-it-yourself on TurboTax project. Particularly when you get into freeing up credits used in prior years, or alternative minimum tax differences. This means you’ll need to get a professional involved, and a relatively small refund can be quickly eaten up by the professional fees needed to complete the filing.
Your next consideration should be the type of income you have had in the past five years, and the type of income you expect in the future. If for example, you have had mostly capital gain income in the last few years, but going forward you expect to have more ordinary income, you may get more bang for your buck by carrying the loss forward. This is due to the preferential tax rates applied to capital gain income, which are typically significantly lower than ordinary rates. If you can choose to offset income taxed at 35% rather than 15%, that would generally be a better use of the NOL.
In addition to looking at the types of income you have had and expect to have, you and your tax professional will also want to look at the types of tax you have paid. Certain types of tax, such as self-employment tax, cannot be offset by net operating losses. For purposes of the alternative minimum tax, the amount of your NOL will oftentimes be different. This means that if you were in AMT in prior years, that carryback may not help you as much as you think.
Lastly, all NOL carrybacks are manually processed by the IRS, and require specific and voluminous attachments in order to be successful. Carrybacks are likely to be scrutinized, and large refunds often result in an audit. This means more cost and more headache. That being said, carrybacks can be an extremely valuable tool for taxpayers with net operating losses. Just be aware that the process might be a lengthy one, and be sure that the refund justifies the work and cost involved.
If you need help with your NOL questions, don’t hesitate to contact a Henry+Horne professional adviser.
Austin M. Bradley, CPA