What is a Loss Carryforward
Loss carryforward refers to an accounting technique that applies the current year's net operating losses to future years' profits to reduce tax liability and track profits accurately. Generally accepted accounting principles (GAAP) specify that loss carryforwards can be used in any one of the seven years following the loss, but tax collection agencies allow varying amounts of time for loss carryforwards depending on the tax entity, the type of loss and other factors.
BREAKING DOWN Loss Carryforward
For example, if a company experiences negative net operating income (NOI) in year one, but positive NOI in subsequent years, it can reduce the amount of future profits it reports using a loss carryforward to report some or all of the loss from the first year in the subsequent years. This results in lower taxable income in positive NOI years, and reduces the amount the company owes the government in taxes. Imagine a company lost $5 million one year and earned $6 million the next. The loss from the first year can be carried forward and included in the current balance sheet for the second year, lowering the profits, and therefore the taxable income, for that year to $1 million.
Loss Carryforward and the Internal Revenue Service
The Internal Revenue Service (IRS) allows businesses to carry net operating losses (NOL) forward 20 years. After that point, the losses expire and can no longer be used to reduce taxable income. Individuals with capital losses can only claim up to $3,000 in capital losses against their income, but if they have losses greater than this amount, they may carry them forward to future years. For example, if an individual has $9,000 in capital losses, he may claim $3,000 the current tax year, $3,000 the following year and the final $3,000 the year after that.
Loss Carryforward vs. Loss Carryback
Loss carryback works the same way as loss carryforward. Essentially, a business or taxpayer applies losses from one year against gains or profits from another year. However, loss carrybacks are applied to past years' earnings, while carryforwards apply to future years' earnings.
The IRS also allows businesses and individuals to carry losses back against previous years' earnings to retroactively reduce their tax liabilities for those years, but the agency has different carryback rules for different types of losses. For example, most losses, including personal capital losses, can be carried back for only two years, but farm losses can be carried back for five years. Similarly, specified liability losses can be carried back for 10 years. In most cases, to carry forward a loss, the tax filer must waive his right to carry back the loss.
Using Loss Carryforwards Effectively
To use loss carryforwards effectively, businesses should claim them as soon as possible. The losses are not indexed with inflation, and as a result, each year the claim effectively becomes smaller. For example, if a business loses $100,000 in the current tax year, although it may carry the loss forward for the next 20 years, it is likely to have a larger impact the sooner it is claimed. As a result of inflation, it is most likely that $100,000 will have less buying power and less real value 20 years from now.