What Is a Loss Carryback?

A loss carryback is an accounting term that describes a situation in which a business experiences a net operating loss and chooses to apply that loss to a prior year's tax return. This results in a lower tax bill for the year to which this "carried back" loss has been applied because it reduces the tax liabilities for that previous year.

Key Takeaways

  • A loss carryback allows a firm to apply a net operating loss to a previous year's tax return.
  • The carryback lowers a prior year's taxable income instead of the current or future years.
  • A tax loss carryforward, on the other hand, applies a tax loss toward future years' returns.

Loss Carryback Explained

Loss carrybacks are similar to loss carryforwards, except companies apply their net operating losses to preceding rather than subsequent years' incomes. Unless certain circumstances are present, a loss carryback can only be applied to the two years preceding the year the net operating loss occurred.

The loss carryback can generate a tax refund for the business for that previous year because of this newly reduced tax liability. After the carried back loss is applied, it will be as though the business overpaid its taxes for that year. Typically, losses can only be carried back two years prior to the year in which the net operating loss occurred. Special circumstances allow for a three-year loss carryback

A business can choose how to apply a net operating loss when such a loss occurs. It can choose to carry the loss back, or it can choose to carry it forward. A business may choose to carry the loss forward if it expects increased tax liability in the future. However, once a choice has been elected to carry the loss back or forward, the action cannot be reversed.

A carryback will be preferred to a carryforward when the time value of money shows that tax savings in the present are more valuable than in the future.

Example of Loss Carryback

For instance, if a company were to record a net operating loss in its fifth year of business, the company could apply a loss carryback to year three of its business. If the loss carryback completely offset the entire tax liability experienced by the business in year three, then the remaining loss could be applied to year four. If there was still a loss amount left over after eliminating the tax liability of year four, the additional loss amount could then be applied to operating year six, seven, and so forth until the amount of the loss was completely used. While loss carrybacks can typically only go back two years, a loss carryforward can extend for up to 20 years after the year the net operating loss occurred.