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:
- What Is a Net Operating Loss?
- How to Calculate Net Operating Loss?
- How Long Can You Carry Forward Net Operating Losses?
- What Is a Net Operating Loss Deduction in Accounting?
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.
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:
According to the IRS, to have a net operating loss, it must be caused by certain deductions. These include expenses related 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% = $85,000 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. Alternately, 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.