A net operating loss (NOL) occurs when a business owner or individual has more allowable tax deductions than taxable income. In other words, the business has a negative income. A business owner may be able to take NOL and move it to future tax years in which it had a profit, reducing its tax burden.
Learn how to calculate net operating loss and how it affects your business and personal tax situation.
Definition and Example of Net Operating Loss
A net operating loss (NOL) is a situation in which the annual tax deductions of a business or other entity are worth more than the owner's adjusted gross income (AGI) on their personal tax return. The owner may be able to use this loss to offset other income on their personal tax return, reducing the owner's total tax bill.
Instead of taking all of the NOL deduction on the year of the loss, a business may carry some of those deductions forward to years when it has a profit, effectively decreasing its tax bill in those years.
Net operating losses are losses on business operations. Capital gains and losses on capital assets and investments are calculated and taxed using a different process.
Who Can Take Deductions on a Net Operating Loss?
A business, individual, estate, or trust can have an NOL, but a loss from operating a business is the most common reason for it. Sole proprietors and single-member LLC owners can take an NOL. Partnerships, S corporations, and LLCs taxed as partnerships can't take an NOL, but the partners, LLC owners, or S corporation owners can take a loss on their share of the total business loss.
Corporations can also have a net operating loss, but this loss doesn't affect individual owners (shareholders).
What's the Calculation for Net Operating Loss?
To calculate your net operating loss, subtract your deductions, either the standard deduction for your filing status or itemized deductions, from your AGI.
Example of a Net Operating Loss
Here's an oversimplified example of an NOL for a sole proprietor:
An individual taxpayer takes the standard deduction of $12,400 and has an AGI of $11,000, including wages from a part-time job, interest income, and a business loss. The person has a preliminary net operating loss of $1,400, but they will have to adjust the amount of the loss for some disallowed deductions.
How Net Operating Losses Work
Most net operating losses are related to business losses. To take the loss, you must include it on your personal tax return, along with other deductions, credits, and income.
While different entities can claim an NOL, there are limitations on the types of deductions that can be factored into the equation. To calculate the amount of an NOL, you can use some nonbusiness deductions, including:
- Contributions to an individual retirement account (IRA) or self-employed retirement
- Your work as an employee
- Losses due to casualties or theft
- Rental property
Certain types of losses and deductions aren't allowed when calculating NOL, including:
- Capital losses (from investments or sale of business assets) in excess of capital gains
- Gains excluded from the sale of small business stock
- Nonbusiness losses
- Section 199A (Qualified Business Income) deduction
Carrying Forward Excess Net Operating Loss
Tax laws limit the amount of net operating loss you can take in any one year. But If you had an NOL in any one year that exceeds the limit, you may be able to take that deduction in future years when you have a profit. This process is called a tax loss carryforward. There are specific rules for calculating the amount of allowable loss.
The 2020 CARES Act temporarily allowed loss carrybacks and 100% NOL deductions for the 2018, 2019, and 2020 tax years. The provisions of this law ended December 31, 2020.
Calculating and Reporting a Net Operating Loss
To calculate and report NOL, here are some key steps to follow:
- Begin by completing your tax return for the year, including your business income or loss.
- Use the calculation above to get a tentative calculation for NOL.
- Check to see if you have a net operating loss. You can use the worksheet o page 3 of IRS Publication 536 Net Operating Losses to see the steps in this process.
- Decide if you have an excess loss that can't be taken totally in a year, or if you want to carry a part of the NOL over to a future year, and how to calculate the carryforward amount.
- Report the NOL deduction amount from your business on the "Other Income" line of Schedule 1 (for Form 1040). If you are claiming a carryforward, enter the NOL deduction as a negative amount. For carryforwards, you must also attach a statement describing all the important facts about the NOL, including how you calculated the deduction.
Getting Help With NOL
The process of determining, calculating, and carrying over an NOL is complicated. The IRS has limits and restrictions on this process and the amounts you can carry forward and the calculations are daunting. Get the help of a tax professional if you think you have an NOL and you want to use it to reduce taxes.
- A net operating loss occurs when a small business's tax deductions are higher than its adjusted gross income.
- Business owners, estates, and trusts can claim a net operating loss.
- While the business may have a net operating loss, it's the owner who takes the loss for the year on their personal tax return.
- Net operating losses may be limited in one tax year, but losses in excess of the limits for a year may be carried forward to offset gains in future years.
Frequently Asked Questions (FAQs)
What is the formula to calculate net operating loss?
The basic formula for calculating net operating losses for an individual taxpayer is to subtract the total tax deductions for the year, including the standard deduction, from adjusted gross income. But the actual calculation is much more complicated. Some types of deductions are not allowed, including:
- Losses on the sale of capital assets (like buildings, equipment, and vehicles) that are more than capital gains on those assets
- Exclusions from gains on qualified small business stock
- nonbusiness deductions greater than nonbusiness income
- The section 199A deduction for qualified business income
- The NOL deduction itself
IRS Publication 526: Net Operating Losses has a worksheet on page 3 that takes you line by line through the process of calculating net operating losses for a specific tax year.
Are net operating losses bad?
Certainly, a business loss isn't as good as a profit, but you can use a loss to offset other income on your tax return. A net operating loss in one year may be limited, but the IRS allows businesses to move these losses to offset gains (profits) in later years, through a process called loss carryforward. Because business profits and losses fluctuate from year to year, this process can help you even out taxable income over several years.
For example, you could have a loss of $100,000 in one year and carry that loss over to several future profitable years to reduce your taxes in each of those years until the full amount of the loss has been taken.
How many years can NOLs be carried back?
Effective with the 2021 tax year, you can no longer carry back a loss from one year to a previous year. But you can carry a loss forward to later years. Net operating losses may be carried forward indefinitely, but deductions are limited to 80% of taxable income.