While running a business, not every year can be profitable. Especially during the start-up phase, your business may not be making enough income to support the amount of expenses that it costs to run your daily operations. This is what’s called a “Net Operating Loss”, or NOL. While losing money can be daunting, NOL can act as a tax deduction to reduce the amount of taxable income that your business will have to pay.
Understanding how NOL works and how to apply it properly can be a valuable tool for your business tax planning. Here we will break down the necessary info for you on NOL!
Net operating loss will occur when the deductible business expenses exceed your income earned. This can occur for numerous reasons. Perhaps your projected sales did not match up with what was actually sold, or you overspent too much in one certain area of the business.
In order to figure out NOL, you can use the NOI formula to calculate your total income after expenses.
While this formula may be for NOI, it becomes NOL once the result from your total income and operating expenses is a negative number.
Your start-up business in its first year made $150,000 in revenue but had $200,000 in operating expenses.
$150,000 - $200,000 = -$50,000
Your business would have a net operating loss of $50,000 since your expenses exceeded your total income.
While loss can be a discouraging factor, especially in a start-up phase, NOL gives you a tool that can make your business pay less in income taxes the following year. This is called “Carry Forward.”
So your business did not do so well in total income, and your expenses exceeded your expectations. Now your business has to report an NOL; however, this can be used to your advantage. “Carry forward” allows you to reduce some of your taxable income in your current year by your reported NOL.
While carry forward can be a great way to avoid paying a large amount of taxes in one tax year, there are some rules that you have to keep in mind.
While you can carry forward your NOL to deduct future taxes, you cannot carry back your NOL and use it as a way to receive a refund on taxes already paid.
If you were thinking about a tax-free year, think again. You are only able to use an NOL deduction on 80% of your taxable income. This means that if you reported a NOL from year 1 and it is more than your taxable income from year 2, you are only able to use that NOL on 80% of your taxable income from year 2.
If your business is not a C corp or S corp, then there are a bit more limitations.
Those who file single on their taxes have a $305,000 cap that can be carried forward.
If filed jointly, there is a cap of $610,000 that can be carried forward.
Any amount above those limits will be considered an excess business loss and will become a net operating loss (NOL) that can be used in future years.
To better understand how carryforward works, here is an example to help.
Your start-up company reports an NOL of $50,000 in its first year.
In year 2, your business earns $100,000 in taxable income.
Here’s how you can apply the carry-forward tool:
80% of $100,000 (Year 2 taxable income) = $80,000
This means that there is a limit of $80,000 of NOL that can be used towards your taxable income in year 2.
$100,000 - $50,000 = $50,000
This means that in year 2, you will only have to pay $50,000 in taxable income.
Net operating loss can seem discouraging, especially to a start-up business. However, this can also be used as an opportunity to lighten your future tax expenses.
Navigating taxes can be a bit complex, especially when you are talking about negative numbers. At LedgerFi, our team is up and ready to help with your tax needs; reach out to our team today!