Business owners typically hope to yield more profits than losses each year. When they do lose more money than they gain, they incur what is known as a net operating loss, or NOL. NOLs can have different tax implications for business owners because the IRS typically will refund some or all of the losses. It is important that they understand how to determine any NOLs their businesses sustained and what to do with these losses after they file taxes.
Determining a Net Operating Loss
It is relatively simple to figure out whether or not a business has incurred a net operating loss. To do so, business owners should first tally the losses their businesses sustained during the past year.After they determine their annual business losses, they should then determine their annual gross income, or AGI, on their tax returns. Their AGI must be a negative number in order for them to be eligible for any net operating loss.
Once they have calculated their AGI, they should then add on any non-business deductions that exceeded their non-business income. These deductions can come in the form of:
- Standard deductions
- Itemized deductions
- Personal exemption deductions
- Non-business capital losses
- IRA contributions
- Charitable contributions
- Paid alimony
- Health savings account deductions
- Archer medical savings account deductions
- State income tax
- Moving expenses
- Self-employed health insurance deductions
- Rental losses
- Accounts receivable sale losses
- Sick leave buy back payments
If they still have a negative amount after they add on these non-business deductions, they have incurred an net operating loss for the year. To utilize their NOL as a form of tax relief, it is important that business owners fill out and submit an IRS Form 1045 Application for Tentative Refund. This form allows them to apply their net operating loss to their businesses' past and future taxable income.
Making Use of an NOL
Businesses that are determined to have net operating losses can use these losses as a form of tax relief for both past and future tax obligations. In general, the IRS allows an owner to apply the net operating loss to the past two years' worth of taxable income, as well as up to 20 years' worth of future taxable income.It is important to note, however, that people are generally not given a choice about how much of their NOLs can be applied to past and future tax amounts. Net operating losses typically are applied to the past two years' worth of taxable income, and any remaining amount can then be applied to future taxable income for up to 20 years. After the 20-year mark, the NOL expires and can no longer be used.
In some cases, businesses are allowed to apply NOLs to the past three years' worth of taxable income. This courtesy is generally extended to farmers who have sustained losses because of:
- A casualty
- Theft
- A federally declared disaster
In order to be eligible for this three-year NOL extension, a farm or small business cannot have made more than $5 million in revenue for the past three years.
It is normal for business owners to view profits as more desirable than losses. Even so, the most successful of businesses on occasion lose more money than they make. When business owners spend more cash than they bring in during a year, they can determine if they have a net operating loss. They can use their NOL to relieve prior tax obligations and to reduce what they may have to pay in taxes in the future.
