Do Net Operating Loss Carryforwards Expire?
The rules for net operating loss carryforwards depend on the year the loss was generated, impacting both expiration dates and annual deduction limits.
A net operating loss (NOL) occurs when a business’s tax-deductible expenses are greater than its income in a given year. The tax code allows businesses to use this NOL to reduce their tax liability in profitable years through an NOL carryforward. This ability to offset future profits makes NOLs a consideration in long-term financial planning. The rules governing how these losses can be used have changed, meaning the expiration of an NOL carryforward depends on when the loss was incurred.
NOL Carryforward Rules Before 2018
For net operating losses generated in tax years beginning before January 1, 2018, a specific set of rules applies regarding their expiration. A business had a 20-year window to use these losses to offset taxable income. If the NOL was not fully used within this 20-year carryforward period, any remaining amount expired and could no longer be used for a tax benefit.
A business could use a pre-2018 NOL to offset 100% of its taxable income in a future year, which meant a large NOL could completely eliminate a company’s tax liability. The rules also permitted a two-year carryback, allowing businesses to apply the loss against income from the previous two years for a tax refund. However, a taxpayer could make an election to waive this carryback and only carry the loss forward.
To illustrate, a company that incurred an NOL of $500,000 in the 2016 tax year would have until 2036 to use this loss. If in 2017 the company had taxable income of $300,000, it could use $300,000 of its NOL carryforward to reduce its taxable income to zero. The remaining $200,000 of the NOL would be carried forward, but the 20-year expiration clock that started in 2016 would continue to run.
NOL Carryforward Rules After 2017
The Tax Cuts and Jobs Act of 2017 (TCJA) changed the treatment of net operating losses for tax years beginning after December 31, 2017. The primary change was the elimination of the 20-year expiration date. For NOLs generated in 2018 or later, businesses can now carry them forward indefinitely until the loss is fully utilized, which provides flexibility for new or cyclical companies.
This indefinite carryforward period came with a trade-off. The TCJA introduced a limitation on the amount of the NOL deduction that can be taken in any single tax year. For losses arising in tax years after 2017, the NOL deduction is limited to 80% of the taxable income for that year. This means a company with a large NOL carryforward will still have a tax liability if it is profitable.
For example, a business generates a $1 million NOL in 2022. In 2023, the business has taxable income of $400,000 before considering its NOL. The company can use its NOL carryforward, but the deduction is limited to 80% of that income, which is $320,000. The company would pay tax on the remaining $80,000 of taxable income, and the unused portion of the NOL, $680,000, is carried forward indefinitely.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act provided temporary relief from these rules. For losses that arose in 2018, 2019, and 2020, the CARES Act allowed a five-year carryback and temporarily suspended the 80% income limitation. For tax years beginning in 2021 and later, the indefinite carryforward and 80% limitation are the prevailing federal rules.
Special Considerations for Corporate NOLs
State-Level NOL Rules
The federal framework for NOL carryforwards does not create a uniform system, as states are not required to adopt the federal rules. State laws regarding NOLs vary, creating a complex compliance landscape for businesses operating in multiple jurisdictions. Some states conform to the current federal system, allowing for an indefinite carryforward period and the 80% taxable income limitation.
Many other states have decoupled from the federal changes, retaining rules similar to the pre-TCJA framework, such as a 20-year carryforward limitation. Some jurisdictions have their own unique carryforward periods, such as five or ten years. Some states have also, at times, suspended the use of NOL deductions to address state budget shortfalls. This divergence requires businesses to track their NOLs separately for federal and state tax filings.
Ownership Change Limitations
A corporation’s ability to use its NOL carryforwards can be restricted if it undergoes a major change in ownership. This limitation is governed by Section 382 of the Internal Revenue Code. An ownership change is triggered if, over a three-year period, the percentage of the company’s stock owned by one or more 5-percent shareholders increases by more than 50 percentage points. This can happen through events like a merger, an acquisition, or a large new issuance of stock.
When a Section 382 ownership change occurs, the amount of pre-change NOLs that the corporation can use each year is limited. The annual limitation is calculated by multiplying the value of the loss corporation before the ownership change by the long-term tax-exempt rate, a rate published monthly by the IRS. The purpose of this rule is to prevent “trafficking” in tax losses, where a profitable company acquires a company with large NOLs to use those losses. This makes the NOLs of a target company a less valuable asset in a potential acquisition.