What Is a Loss Carryback?
A loss carryback describes a situation in which a business experiences a net operating loss (NOL) and chooses to apply that loss to a prior year's tax return. This results in an immediate refund of taxes previously paid by reducing the tax liability for that previous year.
- A net operating loss (NOL) carryback allows a firm to apply a net operating loss to a previous year's tax return, for an immediate refund of prior taxes paid.
- A tax loss carryforward, on the other hand, applies a tax loss toward future years' returns.
- A carryback—and the resulting immediate refund of prior taxes paid—is typically more beneficial than a carryforward due to the time value of money.
- NOL carryback provisions in the tax code have been increased, decreased, omitted entirely, and reinstated various times over the years.
- It is important to be aware of the current state of carryback tax provisions.
Understanding Loss Carryback
Loss carrybacks are similar to loss carryforwards, except that companies apply their net operating losses to preceding rather than subsequent years' incomes. The loss carryback will generate a tax refund of prior taxes paid by the business for that previous year due to its newly reduced tax liability. After the carried back loss is applied, it will be as though the business had overpaid its taxes for that year.
A business can choose how to apply a net operating loss (NOL) when such a loss occurs. For example, it can choose to waive the carry back period and only carry the loss forward. However, once the decision has been made to carry the loss forward, the action cannot be reversed. It is important to note that a NOL carryback is typically more beneficial than a carryforward because the time value of money shows that tax savings in the present are more valuable than in the future. There may be very specific instances when a carryforward makes more sense for a certain business, such as when business tax rates increase considerably. However, it's not the norm.
Loss carrybacks have been allowed in various lengths and forms throughout the years, but the provisions frequently change with new tax legislation. Before considering a carryback as a tax planning option, it is important to know where the legislation sits in the present moment.
Tax provisions allowing NOLs to be carried back have ranged from zero to five years, historically. Because it is such a highly beneficial tax planning option to the taxpayer, tax bills have often touched on carrybacks. In times of recession, the length of time taxpayers are allowed to carry back losses has been extended. Carrybacks have also been omitted from the tax code entirely as an option, allowing only carryforwards. It is important to know where the legislation sits at this point in time.
History of Loss Carrybacks
The NOL carryback provision relating to federal income taxes was originally introduced as part of the Revenue Act of 1918. Originally, this federal income tax provision was intended to be a short-lived benefit to companies incurring losses related to the sale of war-related items in the post-WWI era. The initial carryback and carryforward (collectively, carryover) provision was only for one year. The purpose of keeping the provision was to smooth the tax burden for companies whose primary business is cyclical in nature, but not in line with a standard tax year. This is common with agricultural businesses, as they are highly dependent on weather conditions and may have one successful year followed by a year with a major net operating loss.
Over the following years, the allowable duration for carryovers has been extended, decreased, omitted entirely, and reinstated. We will look only at the major changes to the carryback provision over the last few decades.
- The Tax Relief Act of 1997 limited the NOL carryback provision to two years while extending the carryforward provision out to 20 years.
- Carrybacks were extended temporarily to three, four, or five years as a response to both the September 11th attacks on the World Trade Center and the Great Recession in 2009.
- The Tax Cuts and Jobs Act (TCJA), passed in in 2017, has removed the two year carryback provision as of January 1, 2018, with exception for certain farming losses and non-life insurance companies. It also allows for an indefinite carryforward period, but the carryforwards are now limited to 80% of each subsequent year's net income. For the exceptions, insurance companies, other than life insurance, are permitted to carry back NOLs two years and forward 20 years, and the new 80% limitation does not apply. Farming losses are permitted to be carried back two years and carried forward indefinitely, still subject to the 80% limitation.
- In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act effectively delayed the changes put into place by the TCJA until January 1, 2021. The CARES Act also extended the time frame for carrybacks, and now allows a five-year NOL carryback for taxable years beginning after December 31, 2017 and before January 1, 2021. This includes NOLs incurred by non-life insurance companies and farming losses.
Some states have stricter income percentage or time limits on carrybacks or carryforwards for state income tax purposes.
Real-World Example of a Loss Carryback
Tax loss carrybacks got new attention in September 2020 when the New York Times released details surrounding President Trump's 2009 tax return. According to the Times article, "confidential records show that starting in 2010 he claimed, and received, an income tax refund totaling $72.9 million—all the federal income tax he had paid for 2005 through 2008, plus interest." This was made possible through a NOL carryback provision that changed as a result of the Worker, Homeownership, and Business Assistance Act of 2009, signed into law by President Obama.
The 2009 tax law allowed a five-year NOL carryback provision for tax years 2008 and 2009, rather than the two-year carryback provision that was in place at the time. This meant that NOLs incurred during 2008 and 2009 could be applied toward a refund of taxes previously paid in the five years preceding the loss. If the taxpayer elected to carry back an NOL to the fifth preceding year, the NOL carryback was limited to 50% of the taxable income in the fifth preceding year. However, the remaining NOL balance could be carried forward to the fourth preceding year, and so on until the loss was fully exhausted.