Business Loss Carry Forward Rules and Limitations

A business loss carryforward is a tax provision that allows a business to apply a financial loss from one year against future profits. This mechanism helps to average out a company’s tax liability, which is helpful for businesses in cyclical industries or those in a startup phase where expenses often precede revenues. By carrying a loss forward, a business can reduce its taxable income in subsequent profitable years, thereby lowering its overall tax burden over time.

The rules governing these provisions are designed to provide relief during unprofitable periods. Utilizing a loss carryforward allows for a more accurate reflection of a company’s profitability over a multi-year horizon, rather than being penalized for a single year of poor performance. The process involves specific calculations and adherence to limitations established by tax law.

Identifying a Net Operating Loss

A Net Operating Loss (NOL) for tax purposes is a specific calculation determined by federal tax rules, not simply the negative income figure on a business’s profit and loss statement. An NOL can be generated when a taxpayer’s deductions from a trade or business are greater than the income from that trade or business. For individuals operating as sole proprietors, partners, or S corporation shareholders, these business losses pass through to their personal tax returns.

The calculation begins with the adjusted gross income (AGI) on an individual’s tax return, which must be a negative number to potentially have an NOL. From this starting point, several deductions must be added back. For example, you cannot include any NOL deduction carried over from other years in the calculation of the current year’s NOL, and the Qualified Business Income (QBI) deduction is not permitted when figuring an NOL.

Other adjustments include limitations on nonbusiness deductions and capital losses. Nonbusiness deductions, such as the standard deduction, are only allowed to the extent of nonbusiness income. Likewise, nonbusiness capital losses can only be deducted up to the amount of nonbusiness capital gains. IRS Publication 536 and the worksheet on Form 1045, Schedule A, provide a detailed framework for these calculations.

For example, consider a sole proprietor with a business that resulted in a $70,000 business loss. If this individual has no other income, their AGI would be negative $70,000. To calculate the NOL, they would start with this negative AGI and add back any non-allowed deductions, such as the standard deduction, to determine the NOL amount that can be carried forward.

Applying the Carryforward Rules

Once an NOL has been calculated, specific rules govern how it can be used. Under changes from the Tax Cuts and Jobs Act (TCJA), NOLs arising in tax years after 2017 can be carried forward indefinitely. The TCJA also eliminated the ability to carry back an NOL for most businesses. For losses arising in 2021 and later, no carrybacks are permitted, though a temporary five-year carryback was allowed for losses from 2018-2020.

A primary rule when applying an NOL carryforward is the 80% limitation. For losses generated after 2017, the deduction in a future year is limited to 80% of that year’s taxable income, calculated before the NOL deduction itself. This means a business cannot use an NOL to completely eliminate its tax liability in a profitable year. Any portion of the NOL that remains unused due to this limitation can be carried forward to subsequent years.

To illustrate, a business incurred an NOL of $100,000 in Year 1. In Year 2, the business has taxable income of $50,000 before considering the NOL. The maximum NOL deduction it can take in Year 2 is $40,000 (80% of $50,000), which reduces its taxable income to $10,000. The remaining $60,000 of the NOL is then carried forward to Year 3 and beyond, subject to the same 80% limitation.

NOLs generated in tax years before 2018 are not subject to this 80% limitation and can offset 100% of taxable income. If a taxpayer has carryforwards from both pre-2018 and post-2017 years, the pre-2018 losses are applied first to reduce taxable income. The 80% limitation is then applied to the remaining taxable income when using the post-2017 losses.

Limitations on Deducting Business Losses

Separate from the rules for carrying forward an NOL is the Excess Business Loss (EBL) limitation. This rule applies to noncorporate taxpayers, such as sole proprietors, partners, and S corporation shareholders. The EBL rule limits the total amount of net losses from all trades and businesses that an individual can deduct against their non-business income in a single tax year.

This limitation is applied before determining the NOL. For 2025, the threshold for disallowed losses is $313,000 for single filers and $626,000 for married couples filing jointly. If a taxpayer’s total net business losses exceed this annual threshold, the excess amount is disallowed as a deduction for the current year.

The disallowed amount is not permanently lost; the excess business loss is treated as an NOL carryforward to the following tax year. This disallowed portion becomes subject to the NOL carryforward rules in subsequent years, including the 80% of taxable income limitation. This provision was extended by the Inflation Reduction Act and is scheduled to apply through 2028.

For example, a single individual has a business loss of $400,000 in 2025. The EBL threshold for a single filer in 2025 is $313,000. The taxpayer’s loss deduction for the year is limited to $313,000, and the remaining $87,000 is considered an excess business loss. This $87,000 is not deductible in 2025 but is carried forward to 2026 as an NOL.

Reporting the Loss Carryforward on Tax Returns

For individuals, including sole proprietors, partners, and S corporation shareholders, the NOL deduction is reported on Schedule 1 of Form 1040, “Additional Income and Adjustments to Income.” The amount of the NOL deduction is entered as a negative number on the line designated for “Other income.”

C corporations report their NOL deduction on Form 1120, U.S. Corporation Income Tax Return. The NOL carryover from prior years is entered on a specific line within the “Deductions” section of the form, which then reduces the corporation’s taxable income.

Regardless of the entity type, a statement must be attached to the tax return for any year an NOL deduction is claimed. This statement should provide a detailed account of the NOL. It must show the calculation of the original NOL, list the tax years in which the NOL occurred, track any amounts used in previous years, and calculate the remaining NOL balance available for the current tax year.