How Do Net Operating Loss Expiration Rules Work?

A net operating loss (NOL) occurs when a company’s or individual’s tax-deductible expenses are greater than their taxable income in a given year. This situation results in a negative taxable income, which can be used to offset taxes in other years. The regulations governing how these losses can be applied have changed significantly, creating different sets of rules depending on when the loss occurred. The ability to carry a loss to a profitable year can result in a refund of past taxes paid or a reduction of future tax liability.

Carryover Rules for NOLs Arising Before 2018

For net operating losses generated in tax years starting before January 1, 2018, a distinct set of rules applies. These regulations allowed taxpayers to carry a loss back to the two preceding tax years. This carryback provision could generate an immediate tax refund by applying the current year’s loss against income from a past, profitable year where taxes were already paid. If the loss was not fully used in the two prior years, it could then be carried forward.

The carryforward period for these pre-2018 NOLs was limited to 20 years. If a taxpayer could not use the full amount of the loss to offset income within this 20-year window, any remaining NOL would expire and could no longer be used.

Taxpayers also had the option to waive the two-year carryback. By making a formal election with the IRS, a taxpayer could choose to forgo carrying the loss back and instead only carry it forward. This decision was often made if the prior two years were also loss years or had very low income, making the carryback less valuable than preserving the entire loss for future years. The choice to waive the carryback was irrevocable once made for a specific NOL.

Carryover Rules for NOLs Arising in 2018 and Later

The Tax Cuts and Jobs Act of 2017 (TCJA) altered the treatment of net operating losses for tax years beginning after December 31, 2017. A significant change was the elimination of the 20-year expiration date for NOLs. Under the new rules, these losses can be carried forward indefinitely until they are fully utilized.

In conjunction with making carryforwards indefinite, the TCJA generally eliminated the option to carry back NOLs. For most businesses, losses arising in 2018 or later cannot be applied to past tax years, though an exception was provided for certain farming losses, which retained a two-year carryback provision.

A new provision introduced was a limitation on the amount of the deduction. For tax years beginning after 2020, the NOL deduction is limited to 80% of the taxable income for that year, calculated before the NOL deduction itself. This means a taxpayer cannot use an NOL carryforward to completely eliminate their tax liability in a given year. For instance, if a business has $1 million in taxable income and a large NOL carryforward, it can only use the NOL to offset $800,000 of that income, leaving $200,000 as taxable.

This 80% limitation applies only to NOLs that arose in tax years starting after 2017. If a taxpayer is using older, pre-2018 NOLs, those are not subject to this income limitation and can offset 100% of taxable income. The rules require that pre-2018 NOLs be used first before applying any post-2017 NOLs.

Temporary Rule Changes Under the CARES Act

In response to the economic impact of the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law in March 2020. This legislation temporarily and retroactively suspended some of the NOL rules established by the TCJA. The changes were aimed at improving cash flow for businesses by allowing them to access immediate tax refunds.

A notable change was the reintroduction of a carryback period for certain NOLs. For losses arising in tax years 2018, 2019, and 2020, the CARES Act permitted a five-year carryback. This allowed businesses to take a loss from one of those years and apply it against taxable income from as far back as five years prior. Since federal corporate tax rates were higher in years before 2018, carrying a loss back could result in a significant refund.

The CARES Act also temporarily suspended the 80% taxable income limitation. For tax years beginning before January 1, 2021, taxpayers could use their NOLs to offset 100% of their taxable income. This applied to both new NOLs and carryforwards from prior years.

These favorable rules were explicitly temporary. The general rules established by the TCJA, including the elimination of most carrybacks and the reinstatement of the 80% income limitation, came back into effect for tax years beginning after December 31, 2020.

State-Level NOL Treatment

The treatment of net operating losses at the state level often differs from federal regulations. Each state has the authority to establish its own rules regarding income taxation, leading to a varied landscape for businesses that operate in multiple states.

State conformity refers to the degree to which a state’s tax code aligns with the federal Internal Revenue Code. Some states have “rolling conformity,” meaning they automatically adopt federal tax law changes as they occur. Other states have “static conformity,” where they conform to the federal code as of a specific date, meaning subsequent federal changes are not automatically adopted.

Many states did not adopt the TCJA’s indefinite carryforward period or the 80% income limitation. It is common for states to retain their own carryforward periods, which might be 10, 15, or 20 years. Similarly, when the CARES Act introduced the five-year carryback, many states chose to “decouple” from this provision, meaning they did not allow the same carryback for state tax purposes.

This divergence requires taxpayers to perform separate NOL calculations for federal and state income tax returns. Taxpayers should consult the specific tax laws of the states in which they file to ensure compliance and properly manage their state-specific NOLs.