Net Operating Loss Carry Back

If total of your deductible expenses for a tax year is more than your gross revenue, you have a Net Operation Loss (NOL). The division of accounting periods into separate years can result in unfair taxation for the business that has a large net profit in one year and a net operating loss the following year.

Here’s an example:

Carlton Interior Design opens its doors in June, 2007. They come close to breaking even for the period June 1, 2007 – December 31, 2007, with a net income of $30. Carlton has a very good year in 2008 and reports a net profit of $235,500. In 2009, one of Carlton’s commercial clients goes out of business, and other clients put off redecorating until the economy improves. In January, 2009 alone, Carlton’s expenses are $ 3,000 more than their receipts. By June, 2009, a second large client has gone into bankruptcy, owing Carlton $75,000, and Carlton has a year-to-date net operating loss of $195,000. If Carlton used a July 1 – June 30 fiscal year, their net income for the period would have been $15,000. By the end of 2009, business has picked up a little, and Carlton finishes the year with a net operating loss of $150,000. Carlton’s net income for the two year period ending December 31, 2009 was $85,500, or an average of $42,750 per year.

The tax law allows taxpayers that are in situations similar to Carlton’s to carry back net operating losses and receive a refund of taxes paid for the earlier year. Net operating losses can be carried back two years. When Carlton's 2009 net operating loss of $150,000 is carried back to 2007 and 2008, Carlton has a tax refund of $45,000. Such refunds can make the difference between being able to stay in business or going under.

Instead of carrying a net operating loss back to a prior year, a taxpayer may elect to only carry the loss forward. The election has to be made when the loss-year tax return is filed, and the taxpayer cannot later change their mind.

A business would want to elect a carryforward if it anticipated having higher income in the coming years than it had in prior years, thus making the loss more valuable in the future. In cases other than very obvious ones (for example where there was no taxable income in prior years), it’s difficult to determine “in your head” whether it would be beneficial to make the election to forego the carryback. 

The best way to make the decision whether or not to carry back a loss is the actually do the calculations to see which way is better, taking into account the time value of money, since the carry back results in an immediate refund, whereas the carry forward does not.

You can carry a net operating loss forward to offset future taxable income for up to twenty years, or until the loss is "used up," whichever happens first.