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11 Min. Read

How to Calculate Net Operating Loss: A Step-By-Step Guide

When your allowable deductions exceed the gross income in a tax year, you have net operating losses. To calculate the net operating loss for your business, you need to subtract your tax deductions from the taxable income for the year.

What this article covers:

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.

What Is a Net Operating Loss?

A net operating loss is a tax credit that occurs when the business tax deductions are more than its taxable income in a year. This loss is carried forward in future to set off future profits, thus reducing the tax liability of the business.

In the initial years, most businesses don’t make any money. When this happens, the IRS offers tax relief in the form of net operating loss (NOL). This means that business owners don’t owe any taxes for the particular year. What’s more, they might also get a refund for the taxes paid in the previous years or use the losses to reduce future tax payments.

The most common cause of NOL is the loss incurred while operating the business. Some other problems that might contribute to NOL include property damages, natural disasters, business expenses, theft, moving costs and rental property expenses.

The losses can be carried back two years prior to the NOL year or carried forward for 20 years. Carrying your net operating losses back or forward will apply these losses to the income tax returns from past or/and future years and reduce your tax liability.

Is Net Operating Loss Bad?

Though it is called an operating loss, the NOL deduction isn’t necessarily a negative number or a bad thing. Remember, you can carry forward your losses to future years to reduce or eliminate tax deductions. This can be very helpful if your business is just starting out and you aren’t earning much in the first few years.

Many businesses take several years to turn a profit. Even the first few profitable years are often not overly profitable. By utilizing the net operating loss from previous years, you can keep much more of that profit. This makes net operating loss a very good thing for business owners.

Here are some other positives about net operating loss:

  • It’s a tax credit, so it reduces your taxes.
  • You can claim the loss in future years if your business is still operating. If you sell your business, you are able to carry the net operating losses forward for up to 20 years afterward.

How to Calculate Net Operating Loss?

On a business expense sheet, the net operating loss is calculated by subtracting itemized deductions from adjusted gross income. If the result is a negative number, you have net operating losses.

This item is displayed on line 41 on Form 1040, U.S. Individual Income Tax Return.

The steps for calculating the net operating loss for corporations are:

Determine Eligibility

According to the IRS, to have a net operating loss, it must be caused by certain deductions. These include expenses related to trade or business, casualty and theft losses, your work as an employee, moving expenses and/or rental property expenses.

The net operating loss is applicable only to pass-through businesses, including sole proprietorships. The IRS says partnerships and S corporations cannot claim net operating losses. However, individual partners or owners can find out their share of the loss on their individual tax returns.

Rules for Deductions

The use of net operating losses is subject to certain restrictions. The list of excluded items are:

  • Deduction for personal exemptions
  • The net operating loss deduction
  • Deduction for domestic production activities
  • Any net capital losses (when capital losses are more than capital gains)
  • Nonbusiness deductions in excess of nonbusiness income
  • The section 1202 exclusion of the gain from the sale or exchange of qualified small business stock

Calculate the Net Operating Losses

The next step is to determine whether you have a net operating loss and its amount. For example, if your business has a taxable income of $700,000, tax deductions of $900,000 and a corporate tax rate of 40%, its NOL would be:

$700,000 - $900,000 = -$200,000.

Because the business does not have taxable income, it will not be paying any taxes for the tax year.

But let’s assume the business makes a profit next year and records a taxable income of $200,000. If it is taxed at the corporate tax rate, it will have to pay $200,000 x 40% = $80,000 in taxes.

Since the business incurred a net operating loss the previous year, it can be used to significantly lower the current year’s tax bill. Alternatively, the amount can be applied against taxable income in previous years for a tax rebate.

Net Operating Loss Carryback or Carryforward

Now set off the net operating loss to the preceding years. Usually, the net operating loss can be carried back to the two tax years before the NOL year and applied against any taxable income to get an immediate tax refund. For example, the NOL for 2017 may be carried back to 2015 or 2016.

In certain cases, the NOLs have a greater carryback period. For example, when there are losses from theft or casualty, small business losses related to a federally declared disaster or losses related to product liability claims.

The remaining amount can be carried forward for up to 20 years and applied to the taxable income. Businesses can also avail the option of waiving off carryback period and directly using the carryforwards. This is worth considering if you haven’t paid taxes for the past two years.

Once the 20-year period is over, the taxpayer cannot deduct any part of the NOL.

If you end up with multiple NOLs over the years, they have to be drawn down in the order in which they were created. This reduces the risk of the net operating losses not being used in the twenty-year period.

How Long Can You Carry Forward Net Operating Losses?

You can carry forward the net operating losses for twenty years after the NOL year for tax reduction. The remaining NOL expires after twenty years and has no value.

If you want to skip the carryback period and instead carry forward the amount of your net operating losses, you’ll need to include a statement with your tax return for the NOL year saying that you’re doing so.

What Is a Net Operating Loss Deduction in Accounting?

Net operating losses are classified as business assets since these losses reduce the amount of taxable income. Under assets classification, the losses are classified as deferred tax assets and presented under the noncurrent assets in the balance sheet.

Calculating the net operating losses is important because they create future tax relief for businesses, especially for the startups that have not started making money yet. The idea behind it is that when the business makes money, it pays taxes, and when it doesn’t, it gets some relief. This is what makes the net operating loss a valuable asset.

What Does It Mean to Operate at a Loss?

Operating at a loss means that the business is bringing in lesser or no money to cover its operating expenses. It happens when the total revenues of the company are less than all other costs. These include overhead, operational expenses and cost of goods sold. The break-even point is when it brings in enough money to cover all these costs.

New businesses are most at risk of operating at a loss because they haven’t started making revenues yet. This is especially true for businesses that have a start-up phase. This can include services and online ventures. In these scenarios, the losses are carried forward to create future tax reliefs.

Businesses can use these deductions to save money and propel growth. They can use these savings to increase marketing budgets or purchase additional products for a lower cost basis.

What are the Limitations of Net Operating Loss?

The net operating loss is a beneficial tax relief, but it also has some limitations.

Firstly, it may be limited by the taxable income. For example, if your business makes an operating loss of $5 million, you cannot use the entire amount to offset the taxable income. There are caps on this deduction.

Secondly, it can only be used when there is a taxable income. The net operating loss cannot be used to offset other business expenses or investment expenses, for example.

Thirdly, it can only be carried forward twenty years and back two years. It also doesn’t always provide a benefit in the earlier tax years.

Can You Sell Net Operating Losses?

Net Operating Losses cannot be freely sold for cash, however, there are instances where a business can benefit from transferring these losses. For example, if your company has net operating losses, you could sell a portion of your company to a third party in exchange for cash.

This process is somewhat limited by the IRS. Ownership changes of greater than 50% will result in significant reductions in the amount you are to deduct. This is known as a 382 limitation.

Examples of Net Operating Loss

Net operating loss is a common principle in accounting. Let's look at some examples of NOL in action.

Example One

A business has $1 million in total sales and has deductions of $800,000. This results in a net operating loss deduction of $200,000. This number would then be used to calculate the final tax amount. Let's say your business is taxed at 30%.

The final number would be $200,000 * 30% = $60,000.

Example Two

A business has $1 million in total sales, but it can't claim any of the deductions. Let's say your business is taxed at 30% again.

The final number would be $1 million * 30% = $300,000.

Example Three

Now let's assume the business has less sales than deductions.  Let's say it has $800,000 in sales and $900,000 of deductions. This results in a final amount of -$100,000, or a net operating loss deduction of $100,000. In this case, since it's a negative number, your business would not be taxed on that amount.

What is the Difference Between Net Operating Loss and Net Income?

Net operating loss and net income are two different numbers. Net operating loss is a business asset since it reduces the taxable income of the company.

Net income represents how much money has been generated by the business. It shows your sales minus all the expenses, including the operating costs and taxes.

Should New Businesses Keep a Negative Net Operating Loss?

Many new businesses end up with a negative net operating loss for the first few years. It's not ideal, but it is completely legal. The numbers are included in future calculations when you are filing your taxes.

Typically, the business will have an increasing net income in future years that offsets this deduction. It may be able to use this deduction in the future if it is profitable.

Businesses can use this deduction to their advantage. It may sound counterintuitive for a business to lose money year over year. However, by having a net operating loss you can use it to offset your taxable income, reducing the amount owed.

This process is beneficial for businesses with large amounts of debt or high costs of goods sold. If they have major expansion plans, this deduction may be used as a means to reduce the tax liability.

This type of deduction makes it possible for new businesses to maximize their marketing budgets or other costs. These types of activities typically  have a larger upfront cost. These then pay dividends down the road as the business expands.

Key Takeaways

Net operating losses are a common principle in accounting. They can be calculated as a loss or as an asset, depending on the circumstances of the company. It's important to note that net operating losses have limitations. They can only be carried forward for twenty years and used to offset taxable income. However, it's important to note that they do provide tax relief and create future tax benefits for the company.

Net Operating Loss can be an important accounting principle for many businesses. It's an important concept to understand when it comes to reducing your tax burden. Always be sure to consult a tax professional if you need assistance. Hopefully this article clears up any questions you may have had regarding net operating loss and how it's used in accounting.