Can Bonus Depreciation Be Carried Forward?
Explore the relationship between large upfront deductions like bonus depreciation and the resulting tax attributes that can be used in later years.
Bonus depreciation is a federal tax incentive that permits businesses to deduct a large portion of the cost of qualifying assets in the year they are placed in service, with the goal of encouraging investment in new equipment. A frequent question arises when this deduction causes a business’s total expenses to exceed its income, resulting in a taxable loss. The benefit of the deduction is not lost, as the resulting loss can be used for future tax planning.
The Net Operating Loss Connection
Bonus depreciation itself cannot be carried forward to a future tax year. When the total deductions on a tax return, including bonus depreciation, are greater than the business’s gross income for the year, the result is a Net Operating Loss (NOL). It is this NOL that can be carried forward to offset income in subsequent years.
This generated NOL becomes a valuable asset that can reduce taxable income in future profitable years. The distinction is important because bonus depreciation has no cap and can be used to create or increase a business loss. For instance, the Section 179 deduction, another method for expensing assets, is limited to the business’s taxable income and cannot be used to generate a loss.
Calculating the NOL Carryforward
The calculation of a Net Operating Loss begins on the business’s primary tax form. For a sole proprietor, this process starts on Schedule C (Form 1040), while a corporation would use Form 1120. This involves compiling all business income and subtracting all allowable deductions.
The bonus depreciation rate is subject to a gradual phase-out. For assets placed in service in 2025, the rate is scheduled to be 40%. It is important for businesses to be aware that these percentages can change based on new legislation, as Congress has considered proposals to restore the rate to 100%.
Consider a hypothetical small business with $150,000 in gross revenue for the year. Its ordinary operating expenses, such as salaries, rent, and utilities, total $120,000. During the year, the business also purchased and placed in service a new piece of equipment for $200,000. Using the 40% bonus depreciation rate, the deduction would be $80,000.
The calculation would be: $150,000 (Revenue) – $120,000 (Operating Expenses) – $80,000 (Bonus Depreciation) = -$50,000. This negative $50,000 is the Net Operating Loss for the year. The bonus depreciation itself is reported on IRS Form 4562, “Depreciation and Amortization.”
For individuals, the final NOL calculation may require adjustments for nonbusiness income and deductions, a process detailed in IRS Publication 536. These modifications ensure the value carried forward represents the true business loss.
Applying the NOL Carryforward in Future Years
For NOLs arising in tax years 2021 and later, there is no carryback option. Instead, they must be carried forward indefinitely. When used, the deduction is limited to 80% of the taxable income for that year, which means a business often cannot use an NOL to completely eliminate its tax liability.
For example, assume the business from the previous section, which generated a $50,000 NOL, has a taxable income of $70,000 the following year. To apply the NOL carryforward, the business would calculate 80% of its taxable income: $70,000 x 80% = $56,000. Since the $50,000 NOL is less than this $56,000 limit, the business can deduct the entire $50,000. This reduces its taxable income for the year to $20,000 ($70,000 – $50,000).
If the business’s taxable income was only $40,000, the 80% limitation would be $32,000 ($40,000 x 80%). In this scenario, the business could only deduct $32,000 of its NOL. This would reduce its taxable income to $8,000, and the remaining $18,000 of the NOL ($50,000 – $32,000) would be carried forward to the next year.
The NOL deduction is claimed on the tax return, such as Form 1120 for corporations or on Schedule 1 (Form 1040) for individuals as a negative income amount. Businesses must maintain detailed records tracking the amount of NOL used each year and the remaining balance available for future use.
State Tax Treatment Considerations
The treatment of bonus depreciation and Net Operating Losses at the state level is not uniform and often differs significantly from federal rules. States are not required to adopt the federal tax code and can choose to “decouple” from specific provisions like bonus depreciation or establish their own distinct NOL regulations.
Some states automatically conform to the Internal Revenue Code as it is updated, meaning they adopt federal changes to bonus depreciation and NOLs unless they pass specific legislation to decouple. Other states practice “static conformity,” where they conform to the IRC as of a specific date, meaning subsequent federal changes are not automatically adopted.
A significant number of states have chosen to fully or partially decouple from federal bonus depreciation. In these states, a business must add back the federal bonus depreciation amount to its state taxable income and then depreciate the asset according to the state’s own schedule.
State NOL rules can vary widely, with different carryforward periods, income limitations, or even temporary suspensions of NOL deductions altogether. Because of this wide variance, a business might have an NOL for federal purposes but show a profit for state tax purposes, or vice versa.