Running a business is an exciting journey, but even the most successful ventures encounter bumps along the road. Sometimes, these bumps can lead to significant financial losses in a particular tax year. This is where Net Operating Loss (NOL) values come in, offering a valuable tax benefit that can help businesses weather the storm.

 

What are NOL Values?

Imagine a year where your business expenses (tax deductions) outweigh your income. This creates a negative taxable income, meaning you wouldn’t owe taxes on that specific year. However, the IRS understands that economic cycles have ups and downs, so they allow you to carry forward these net operating losses (NOL values) to offset future profits and reduce your tax burden in profitable years. It’s like saving up “tax credits” from bad times to use during the good times.

 

Net Operating Loss (NOL) Carryforward

NOLs essentially function as a tax credit for losses incurred in a particular year. However, unlike traditional tax credits that expire at the end of the year, NOLs offer a unique advantage that allows you to average your losses across different tax years: they can be carried forward to offset taxable income in future years. 

Let’s break down the concept with a super simplified example:

  • Year 1: In a previous year, your business generates $100,000 in revenue but incurs $120,000 in expenses, resulting in a NOL amount of $20,000.
  • Year 2: In the current year, your business bounces back and generates $150,000 in revenue. You can use the $20,000 NOL carryover from Year 1 to reduce your taxable income in Year 2 to $130,000, potentially saving you thousands in taxes.

Think of them as financial vouchers issued by the IRS during your low points, redeemable against future profits. This allows you to smooth out your tax burden across different years, potentially reducing your tax liability in profitable years and providing much-needed financial relief during periods of lower income. 

 

Tax Gems: Beyond Income Tax

The ability to carry forward NOL values offers a versatile safety net for various situations when you would need to strategically offset your increased income. There are two specific examples, out of many, I can give you of how a NOL deduction can be strategically leveraged against tax liabilities: Specifically, NOLs can offer relief from Alternative Minimum Tax (AMT) and General Business Credits limitations.

The Alternative Minimum Tax (AMT) is designed to ensure everyone pays a minimum amount of tax, even with deductions and credits. This can unexpectedly impact businesses. By utilizing NOLs to offset taxable income, you can potentially reduce or even eliminate your AMT liability, freeing up a significant portion of your tax burden. This is specifically beneficial for businesses with fluctuating income or those that utilize various deductions that may trigger AMT calculations. Remember, navigating these complexities is best done with the guidance of a qualified tax professional. Contact us for a referral of professionals we have worked with who are knowledgeable in this area.

NOLs can also be leveraged to maximize the benefits of General Business Credits. General Business Credits incorporate a diverse range of tax credits businesses can earn, such as credits for research and development, but come with limitations on their usage. By strategically applying NOLs, you can reduce your taxable income, potentially allowing you to utilize a greater portion of your available General Business Credits that might have otherwise been limited due to high-income levels. This translates to maximizing your tax benefit and further enhancing your financial position. This strategy can be particularly valuable for businesses in their early stages, where initial investments generate credits but current income may be lower, potentially restricting the full use of these valuable tax incentives.

By understanding the versatile nature of NOLs and their ability to offset not just income tax but also other tax liabilities, you can transform them from a passive benefit into a strategic ally.

 

The NOL Carryforward Period

The NOL carryforward period, also known as the carryover period, refers to the time frame within which you can utilize your NOLs. The carryforward period for NOLs varies depending on the tax year in which the loss occurred. 

For companies established after 2020, NOLs can be carried forward indefinitely until fully used. This offers significant flexibility, allowing you to strategically utilize NOLs to offset income in future years, potentially even decades later, maximizing their long-term benefits. 

The rules for NOL carryovers for companies established before 2021 are more complex than those for businesses established after 2020. Generally, a 20-year carryforward period applies. This means you have 20 years from the year the loss occurred to utilize those NOLs to offset taxable income. There is also a “separate basket rule” that applies to companies established after 2021. This means NOLs from each year are treated as a separate “basket” and must be used in chronological order before utilizing NOLs from subsequent years. 

Certain aspects between them do remain similar. The amount of NOLs that can be used to offset taxable income in any given year is limited to 80% of the taxable income (excluding certain deductions). This limitation can restrict the full utilization of NOLs, especially in years with very high taxable income. Finally, certain significant changes in ownership (like a “Section 382 ownership change“) can limit the ability to utilize NOLs after 2020.

There are exceptions and complexities surrounding NOLs arising before 2021 or post 2020. Consulting a tax professional is highly recommended to understand the specific rules and potential limitations applicable to your situation. Contact us if you need a referral to a tax professional who is knowledgeable in this area. 

 

Unexpected Sources of NOLs

While business losses are a common trigger for NOLs, the tax code recognizes that unforeseen circumstances can also create financial hardship. Here are some lesser-known scenarios that can lead to a net operating loss year:

  1. Natural Disasters:

A thriving restaurant is devastated by a flood. The cost of repairs, lost inventory, and business interruption can easily lead to substantial losses that exceeds income in that year. In such situations, the NOL generated can be carried forward to offset profits in later years, providing much-needed financial relief during the rebuilding process.

  1. Strategic Mergers and Acquisitions (M&A):

When two separate companies combine forces to create a new, single entity, this is called a merger. The world of M&A can sometimes create opportunities for NOLs. The original companies cease to exist, and the resulting company inherits the assets and liabilities of both. An acquisition is one company (the acquirer) taking ownership of another company (the target company). Depending on the specific circumstances of the merger or acquisition, a company may be able to absorb the NOLs of the acquired entity. This can be a strategic tax benefit, allowing the combined entity to offset future profits and potentially reduce its overall tax burden. 

 

Case Studies and Examples

Case Study 1: The Business Owner:

Sarah, a passionate entrepreneur, built her bakery from the ground up. Through years of dedication, her bakery became a beloved local institution, consistently generating healthy profits. However, fate took an unexpected turn when a fire ravaged the bakery in 2021. The cost of repairs and lost inventory resulted in a significant net operating loss for that year.

Determined to rebuild, Sarah tapped into her savings and secured a loan. Utilizing the expertise of her tax professional, Sarah explored the concept of NOL carryovers. By understanding the NOL rules, her tax professional determined that Sarah could carry forward the 2021 NOL year to offset future profits. In the following years, as her bakery bounced back and even surpassed its pre-fire revenue, Sarah strategically utilized the NOL carryovers. This allowed her to reduce her taxable income, significantly lowering her tax burden and freeing up valuable capital. These savings were then reinvested back into the business, allowing Sarah to upgrade equipment, expand her menu, and even hire additional staff.

Case Study 2: The Freelance Artist

Michael, a talented but struggling artist, experiences years of minimal income from his artwork. Determined to succeed, Michael persevered, refining his artistic style and actively seeking opportunities to showcase his work. His efforts paid off, as he finally lands a solo exhibition at a prestigious gallery. This event triggered a surge in sales, generating significant income for Michael in a single year. The high income from the exhibition placed Michael in a higher tax bracket, potentially leading to a substantial tax bill. However, he utilized NOLs from prior years to offset his current taxable income. This significantly reduced his tax liability and allowed him to keep more of his hard-earned income. 

These examples highlight the versatility of NOLs and their potential benefit for individuals with fluctuating income streams resulting from nonbusiness capital losses.

 

Tools and Resources 

Identifying the specific opportunities available within your unique financial situation is best left to qualified tax professionals. They possess the years of experience and deep understanding necessary to unravel the intricacies of NOLs and their strategic applications. Don’t carry the burden alone. Let Us Help!

Tax laws are intricate and evolving constantly. From maximizing deductions to planning for future tax implications, a knowledgeable and experienced professional crafts a strategic approach that leverages every opportunity to minimize your tax burden. 

Yari Solutions is a trusted agency with 15+ years of experience that is here to take the burden off your shoulders and turn those blank spaces into tax-saving opportunities. 

If you would like help and would love more in-depth and personalized feedback, strategies, and information based on years of experience, schedule a consultation with us.

Our team possesses extensive experience in identifying accounting issues, problem-solving, analyzing, and maximizing deductions while minimizing potential penalties. Don’t just take our word for it – hear directly from satisfied clients.

 

 

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