What Is a Net Operating Loss (NOL)
A net operating loss (NOL) is a loss taken in a period where a company's allowable tax deductions are greater than its taxable income. When more expenses than revenues are incurred during the period, the net operating loss for the company can generally be used to recover past tax payments. The reasoning behind this is that corporations deserve some form of tax relief when they lose money, so they may apply the net operating loss to future income tax payments, reducing the need to make payments in future periods.
Net Operating Loss (NOL)
Understanding Net Operating Loss (NOL)
A net operating loss (NOL) makes a company unprofitable for tax purposes. For example, Company A has a taxable income of $500,000, tax deductions of $700,000 and a corporate tax rate of 30%. Its NOL is $500,000 - $700,000 = -$200,000. Because Company A does not have taxable income, it does not pay taxes that year. Otherwise it would have paid $250,000 x 30% = $75,000 in taxes. Because the company had an NOL the previous year, it may put the NOL toward the current year’s tax bill or apply it against taxable income in previous years.
Rules for Applying an NOL
A business may carry the taxable amount back to the two previous years and apply it against taxable income for a refund. For example, an NOL occurring in 2019 may be used for lowering tax payments in 2018 or 2017. Because the time value of money shows that tax savings at that time is more valuable than in the future, this is the more beneficial choice. However, if the business did not pay taxes in prior years, or the owner’s income is expected to substantially increase in the future and raise the company’s tax rate, the business may also carry forward the amount over the next 20 years, reducing the amount of taxable income during that time.
If a business creates NOLs in more than one year, they are to be drawn down completely in the order that they were created before drawing down another NOL. Because any remaining NOL is canceled after 20 years, this reduces the risk of the NOL not being used.
Section 382 Limitation
An NOL may be considered a valuable asset because it can lower a company’s amount of taxable income. For this reason, the Internal Revenue Service (IRS) restricts using an acquired company simply for its NOL’s tax benefits. Section 382 of the Internal Revenue Code states that if a company with a NOL has at least a 50% ownership change, the acquiring company may use only that part of the NOL in each concurrent year that is based on the long-term tax-exempt bond rate multiplied by the stock of the acquired company. However, purchasing a business with a substantial NOL may mean an increased amount of money going to the acquired company’s shareholders than if the business possessed a smaller NOL.