The Rules Governing Net Operating Losses are Changing

The phrase “net operating loss” may bring about feelings of despair to a business person.  It may be the case that a business actually lost money in a given year and the owner reported a negative taxable income number on his/her tax return.  Net operating losses (NOLs) for tax purposes do not always mean negative business results.  In some cases, NOLs arise from accelerated tax deductions through depreciation, resulting in positive cash flow for the business, but a negative bottom line for tax purposes.  Regardless of how an NOL was generated, the rules governing their use are changing as a result of the TCJA.  We explore a few of the issues at play in this article:

How is the TCJA affecting your net operating losses?

  • Repeal of the NOL carryback

Prior to the President signing the TCJA into law, a taxpayer that generated an NOL was able to carry the NOL back to offset taxable income in two prior tax years.  This allowed for an almost immediate cash savings related to NOLs that were carried back, as the taxpayer could receive a refund of prior tax paid.  Here is a very simple example of how the NOL carryback might work with an NOL generated in 2016 that was carried back to 2015:

Tax Year 2015 2016
Taxable Income/(Loss) $1,000,000 ($500,000)
Tax Paid      400,000 0
NOL Generated 0 (500,000)
NOL Carried Back (500,000)
Amended Taxable Income $500,000
Amended Tax Liability 200,000
Cash Refund $200,000

The $500,000 loss in 2016 is carried back to offset the $1 million of taxable income in 2015 and reduces the tax liability from $400,000 to $200,000.  This results in a cash refund of $200,000 paid to the taxpayer.  For NOLs generated in tax year after December 31, 2017, the two-year carryback is no longer allowed.

Many new changes are being made based on the rules governing NOL

  • Indefinite carryforward of NOLs

A 20-year carryforward period is retained for NOLs generated prior to the 2018 tax year.  NOLs generated in tax years after December 31, 2017 can be carried forward indefinitely.  Of course, this creates some administrative difficulty in tracking which year each NOL was generated for taxpayers with multiple years of NOLs.   While taxpayers give up the ability to carryback an NOL, they now can carryforward their NOLs indefinitely, without the fear of having them expire unused after 20 years.

  • Post-2017 NOLs can only offset 80% of taxable income

Another differentiation of pre and post-2017 NOLs comes in the form of the new rule that only allows a taxpayer to offset 80% of his/her taxable income with an NOL generated after 2017.  This is most easily explained in an example.

In this case, the taxpayer has a $1 million NOL that was generated in 2015 that he will carryover to 2019.

Tax Year 2019
Pre-NOL Taxable Income/(Loss) $700,000
NOL Carryforward Generated in 2015 (700,000)
Taxable Income/(Loss) 0
Tax Liability 0
NOL Carried Forward to 2020 $300,000

In this case, the taxpayer is able to use $700,000 of his $1 million NOL to offset the entire amount of his pre-NOL taxable income, resulting in no tax liability.

We will use the same set of circumstances with the only change being that the $1 million NOL was generated in the 2018 tax year and will be carried forward to 2019.

Tax Year 2019
Pre-NOL Taxable Income/(Loss) $700,000
NOL Carryover Generated in 2018 (560,000)
Taxable Income/(Loss) $140,000
Tax Liability 35,000
NOL Carried Forward to 2020 $440,000

In this example, since the NOL was generated after 2017, it can only be used to offset 80% of the taxpayer’s pre-NOL taxable income, resulting in a tax liability.

Tracking the year in which an NOL is generated will be extremely important moving forward, as it will impact the ability to carryback the NOL, the length of time the NOL can be carried forward, and the amount of taxable income it can offset.  The TCJA provided both positives and negatives in the NOL arena.  The changes to the treatment of NOLs is only one piece of the puzzle of the entire TCJA package that will continue to be unpacked in 2018 and beyond.