What Is a Tax Umbrella?

A tax umbrella refers to the use by a company of the losses it sustained in previous years to offset taxes on the profits it achieves in future years.

Key Takeaways

  • A tax umbrella is a provision in the tax code that allows for future tax payments to be reduced due to prior losses or tax liabilities.
  • The goal of a tax umbrella is to help a company that has struggled emerge to profitability and sustainability without a huge tax burden.
  • It is known as an "umbrella" since losses in the previous period can be used to cover profits in the future.

Understanding Tax Umbrellas

Tax umbrellas refer to instances in which a company or individual takes advantage of tax law provisions to reduce tax liability. Tax umbrellas reduce future tax payments. In other words, a tax umbrella is a negative profit that reduces a company's tax liability. This typically occurs when a company's tax deductions exceed its taxable income, often because expenses exceeded revenues. Individuals can also utilize tax umbrellas so their investment losses in previous years offset their investment gains in future years.

Businesses and individuals are limited in how much of a loss they can use to offset taxes in any given year. Any loss that is left over can be used to offset taxes on gains in future years, in what is known as a carryforward. Investors can also carry forward losses from selling investments and create tax umbrellas that reduce their future capital gains taxes.

Why Tax Umbrellas Matter

Say that in 2016, Company A has income of $2 million, but expenses of $2.3 million in one year. In this case, Company A’s net operating loss is $2 million minus $2.3 million, so negative $300,000. Because Company A didn’t have any taxable income, the business will likely not owe taxes for the year it incurred the loss. But, let’s say the following year, Company A is much more profitable and brings in half a million dollars of taxable income, putting the company in a tax bracket of 35 percent at the time. Typically, this company would need to pay about $180,000 in taxes, but because it had a tax umbrella from the previous year, it can apply that to this year’s tax bill, reducing the payment owed.

In 2017, Congress replaced the graduated corporate tax structure in the U.S. with a 21% flat corporate tax as part of the Tax Cuts and Jobs Act (TCJA).

Tax umbrellas create cushions for future tax relief, making them valuable assets for companies. In practice, tax umbrellas allow companies to pay taxes when they make money, and get some relief when they don’t. The ways in which tax umbrellas apply to individuals and companies, as well as laws and regulations regarding tax umbrellas, vary by state, which is why it's important for investors and companies to consult with qualified tax accountants when determining tax umbrellas.

Typically carryforwards from the last two to three years can apply for up to seven years. Usually after seven years, the carryforward expires and a company can no longer take advantage of a tax umbrella. Note that the IRS now states that any net operating losses not applied in the previous 5 years can be carried forward each tax year following the year of the loss.