Have your small business deductions surpassed its gross income in a tax year? Then you are in front of a Net Operating Loss, a special tax credit that you can use in favor of your small business.
In this article, we are going to teach you how to calculate the net operating loss for small business taxes in addition to other key aspects such as how much you can deduct with a NOL, the carryback and carryforward rules, and practical examples.
What is a Net Operating Loss for Small Businesses (NOL)?
A net operating loss, often referred to as NOL, is a type of tax credit that small businesses can claim when their tax deductions are higher than their taxable income in a year. For example, if your business incurred losses for $50,000 but it only generated a taxable income of $15,000, then it’d leave you with a Net Operating Loss of $35,000.
The NOL is a form of tax relief that the IRS brings to small business and other types of pass-through entities to compensate for the losses from previous years. Since some businesses are cyclical, and they might generate little profits and register high business expenses, the NOL can help them to minimize the economic damage by reducing their tax liability.
How to Calculate Net Operating Loss for Small Business Taxes in 3 Steps
Calculating the NOL for your small business is easier than you think once you determine if you’re eligible and how to group the business and non-business deductions and income. Here’s how to do it in only 3 steps.
#1 – Determine If Your Small Business Qualifies for a NOL
For your small business to be able to use a NOL as a deferred tax asset to reduce the tax liability of your company in the future years, it must have incurred losses due valid deductions. Some examples are theft, seasonal cycles, Schedule C expenses, rental expenses, limited profits, state income tax on business profits, natural disasters, unexpected business expenses, casualty losses, and investments with a negative ROI.
If you recognize that the losses of your small business have been caused by one or more of these deductions, then you can proceed to calculate the NOL in order to use it to reduce your tax liability.
#2 – Separate the Business and Non-Business Income and Deductions
Now you need to separate all the business income and deductions from non-business transactions, in order to calculate the NOL for your small business. Here is how you need to group it:
| Income | Deductions | |
| Business | Payments for productsPayments for servicesCommissionsSelf-employment incomeTipsSale of business propertyStock gainsRental income (if it’s a rental company) | Casualty lossesRental expensesLosses caused by natural disastersHigh business expensesUnfruitful business investmentsSchedule C expensesMoving expensesState income taxStock lossesLosses caused by theftUnrecovered investment in employee annuity contracts |
| Non-Business | AnnuitiesDividendsSale of non-business propertyTax refundsTrust incomeEstate income | Taxes not related to the small businessContributionsBad debts not related to the small businessMedical expensesInterest expenses |
We recommend you to consult with a tax professional to identify all the business and non-business income and deductions, because they can vary depending on the type of small business you are running.
#3 – Calculate the Net Operating Loss for Your Small Business
After grouping all the business and non-business transactions, you need to perform the following operation:
Net Operating Loss = Deductions – Taxable Income
Let’s suppose that the total of deductions for your small business is $60,000 and the taxable income is $40,000 – here’s how you need to use the formula to calculate the NOL:
Net Operating Loss = $60,000 – $40,000
Net Operating Loss = -$20,000
Now you can record the NOL of $20,000 as a deferred tax asset on the balance sheet of your small business, ready for you to use it in the following years when your company generates profits.
To sum it up, let’s check this example. Consider that your small business, which you run as a sole-proprietorship, has managed to generate $60,000 before taxes, making it a successful year for your company. However, it’d subject you to a tax rate of 22%, but you can take advantage of the NOL from the previous rate to reduce your current tax liability.
Now, let’s subtract the NOL from the taxable income of this year ($60,000 – $20,000), which leaves you a new taxable income of $40,000, which would lower your tax rate from 22% to 12%.
If you want more information about how to calculate the NOL for your small business, then the following sections will bring you everything you need.
A Note About Net Operating Loss Carryback and Carryforward
It is also important to know about the carryback and carryforward rules that will apply to the NOL of your small business. Here you will find all the necessary information.
Small Business NOL Carryback
After implementing the Tax Cuts and Jobs Act of 2017 (TCJA), which was delayed by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, there is no NOL carryback for the tax years that start after 2020. However, companies can still take advantage of a two-year NOL carryback period for farming losses.
A short history on NOL carryback before TCJA
Before the implementation of the TCJA, you could use a NOL carryback to apply the loss to a previous tax return to obtain immediate refund on taxes you have previously paid for your small business. Therefore, a NOL carryback was an effective solution to implement if your company was going through hard times.
This is another reason why you should consult with a tax professional to create an effective tax planning for your small business – because new Acts such as the TCJA, have turned the tax landscape more complex.
Small Business NOL Carryforward
Unliked carrybacks, your small business can claim unlimited NOL carryforwards for all the tax years that begin after 2020. The carryforward period will allow you to offset the losses of your small business in a specific tax year against profits from future profits. Therefore, this will allow you to reduce the taxable income of your small business in future years, effectively reducing your taxes.
Therefore, a NOL carryforward is a valid tax relief method that has to be recorded as an asset in the general ledger of your small business. It will allow you to reduce the tax liability of your company, in order to recover the losses from a year in specific.
However, you need to consider that you can only use the NOL carryforward to deduct up to 80% of each subsequent year’s net income. You will find more information about this in the next section.
How Much Can You Deduct with a Net Operating Loss?
Before 2017, the Net Operating Loss allowed you to discount 100% of it. However, since the Tax Cuts and Jobs Act of 2017 (TCJA) was implemented, it is limited at 80% of the surplus of taxable income disregarding any considerations under § 199A (Qualified Business Income), § 250 (Global Intangible Low-Taxed Income), or the Net Operating Loss (NOL).
For example, if you have a NOL of $50,000 but you only generated a taxable income of $50,000 in the next year, then after applying the new limitation of 80%, you’d only be able to use up to $40,000 from the NOL ($50,000 x 80%). The rest of the NOL, which would be $10,000, will remain on your balance sheet as a deferred tax asset until you fully use it.
However, the Coronavirus Aid, Relief, and Economic Security (CARES) Act delayed the TACJA, and it only started to apply to tax years after December 31, 2020. Therefore, it is possible to deduct 100% of the NOLs generated in tax years beginning before 2021.
The TACJA complicated the tax landscape for thousands of business owners and professionals, because it has made it significantly harder to administer NOLs, especially when you have plenty of carryforward NOLs. Therefore, we recommend you to consult with a tax professional if you are facing this situation to create a proper tax plan.
Grasping the Concept Behind Net Operating Loss for Small Business – Practical Examples
It is normal to find it hard to understand how the NOL works if it’s your first time running a business, because you have never heard about it before. The following examples will help you to understand the concept like a seasoned business owner.
Example #1: When the NOL is Higher than the Maximum Possible Deduction
Consider a small business that had losses (NOL) for $80,000 in one year and earned $90,000 before taxes in the following year. With the 80% carryover limit applied to the $90,000, we have a maximum NOL of $72,000 that you can use for the second year. Because the 80% limitation is calculated using the taxable income and not the total amount of the NOL.
You can carry forward the entire loss from the first year to the balance sheet of the second year as a deferred tax asset to reduce the tax liability of your small business.
Now, let’s apply the NOL from the first year to the taxable income of the second year, which leaves us with the following operation: $90,000 – $72,000, which equals to a taxable income of $18,000 for the second year.
The remaining part of the NOL ($80,000 – $72,000 = $8,000) will remain in the balance sheet as a deferred tax asset and you can carry it forward to the following years.
This new rule makes it problematic for many small business owners to understand how to effectively use the NOL to reduce their tax liability. However, this clear example will help you to grasp the concept.
Example #2: When the NOL is Lower than the Maximum Possible Deduction
For this example, let’s imagine that you are running a boutique marketing agency named “Pixelist Strategies”, and after investing in new equipment, software and training for your team, your small business suffered losses for $50,000 in 2021, creating a NOL that you register as a deferred tax asset on the balance sheet of your company.
In 2022, “Pixelist Strategies” obtains more clients and starts growing, generating $100,000 before taxes. Given that now your tax liability will be higher, you can use the NOL from 2021 to reduce the taxes that your small business has to pay.
Applying the new rules by the IRS, you proceed to calculate the following how much of the NOL you can use with the following operation: $10,000 x 80%, leaving you with the possibility to use up to $80,000. However, since you only had a NOL of $50,000, you can deduct it all, leaving you with a final taxable income of $50,000 ($100,000 – $50,000 NOL) for 2022.
Now that you have used all the credits from the NOL, it will no longer be available for you to use as a deferred tax asset in the coming tax years.
Calculate and Deduct the Net Operating Loss of Your Small Business with Quilca CPA Group
If you want to calculate and deduct the NOL for your small business but you don’t know how to do it, then Quilca CPA Group can help you. Call us at now (786) 310-5582 or send us a message at [email protected] to book a consultation.
