Negative taxable income on a taxpayer's Internal Revenue Service (IRS) Form 1040 tax return is known as a net operating loss (NOL). This may enable a taxpayer to claim a refund for all estimated tax payments and withholding periods in the current year and may be carried forward against future tax years or carried back to generate refunds from past tax years.
A net operating loss for an individual taxpayer usually results from losses incurred in a business entity and then allocated to the taxpayer. Rules in the Internal Revenue Code make it difficult for a net operating loss to result from deductions against other, nonbusiness income. The most common sources of net operating losses are pass-through losses from a partnership or S-Corporation, a loss computed on the taxpayer's Schedule C (Profit or Loss from Business) or a non-passive loss generated from rental real estate activities or from the disposition of passive rental real estate activities.
Offset Against Other Sources
In computing the amount of net operating loss, taxpayers must first use the source of loss to offset other forms of income such as wages or salary, interest or dividend income, capital gains, taxable individual retirement account distributions, capital gains and Social Security income. For example, a taxpayer with a $50,000 net loss from a business, $30,000 of salary income and $5,000 of interest income would have a $15,000 net operating loss. Taxpayers can usually claim a variety of deductions against all sources of income. Most of these may not be used to increase a net operating loss.
Carryback and Carryforward
Taxpayers can usually carryback net operating losses against taxable income in the prior two years and carryforward net operating losses against taxable income for the next 20 years. There are a number of exceptions to the two-year carryback period and certain taxpayers, such as qualified small businesses, farming businesses, and taxpayers in qualified disaster areas may be able to carryback losses for as many as five years. Taxpayers claiming a carryback loss may apply for refunds using either IRS Form 1045, Application for Tentative Refund, or IRS Form 1040X, Amended U.S. Individual Income Tax Return.
Taxpayers can employ numerous strategies to maximize the benefit of net operating losses. Many taxpayers, particularly those with businesses that report income and deductions on a cash basis may be able to accelerate income or deductions and affect the amount of net operating loss. Since taxpayers with a net operating loss cannot claim certain deductions, many will try to avoid a net operating loss, preferring instead to report moderate levels of income across two tax years, rather than a net operating loss in one year and a large amount of income in the next. In addition, taxpayers with low levels of income in prior years may chose to waive carryback provisions and instead carryforward losses against future income, which the taxpayer believes will be taxed at higher marginal rates.