Net Operating Loss Carryforward Explanation

Although business owners start companies with the intention of generating a profit that helps them increase their wealth, many companies do not generate a profit in their initial years. Companies may incur significant start-up costs, make operational mistakes, or simply not attract enough customers to make money. When this happens, companies incur a net loss. This net loss, when used in future years to offset net profit, is called a net operating loss carryforward.

When a business operates it generates costs. Even those companies run as a side business while the owner works full time can generate a number of expenses. These expenses include advertising and marketing, equipment, meals and entertainment, vehicles, and rent. The Internal Revenue Service considers all of these expenses deductible business expenses for tax purposes. When your company generates more deductible business expenses than it does sales, then it incurs a net operating loss, or NOL.

Your company must pay taxes on any net income it generates, but it does not get a tax credit on any net loss generated. Instead, you use the net operating loss from a prior year to reduce the net income your company generates in another year. If your company was unprofitable and lost money for three years in a row, your company would accrue an NOL over those years.

The IRS rule is that you first carry back an NOL for two years. If all or a portion of your company's NOL still remains, you use the NOL to reduce your company's taxable income in the years following. You can use an NOL for up to 20 years following the creation of the NOL. If you incurred huge expenses in your initial years or generate low profits in ensuing years, you may need the full 20 years. Since you carry the net operating loss forward, you use the term "carryforward." You forfeit any NOL that remains after 20 years.

In general, you must use all of the net operating loss as a deduction from taxable income in each following year until you zero out the NOL. If your company generates an NOL in each year for three years, then IRS rules mandate that you apply the first year's NOL as the beginning year.

XYZ Landscape Inc. had taxable income of $50,000 in fiscal year 2013, but XYZ had a negative operating loss of $100,000 in FY 2012, its first year of operation. Since the corporation did not exist before then, it can only use its NOL as a carryforward. XYZ Landscape deducts its $100,000 NOL from FY 2012’s $50,000 taxable income, and reduces its FY 2013 net taxable income to zero. This results in a tax liability of zero. It then has $50,000 remaining as an NOL to carryforward to FY 2014 and beyond.