How to Apply a Carryback NOL to Reduce Tax Liability

A net operating loss (NOL) occurs when a business or individual’s tax-deductible expenses exceed taxable income. The IRS allows taxpayers to use an NOL to offset past or future income, potentially reducing tax liability. One way to utilize an NOL is through a carryback, which applies the loss to prior years’ tax returns, resulting in possible refunds.

Applying an NOL carryback requires understanding specific rules, deadlines, and documentation. Navigating this process effectively can help maximize tax benefits while ensuring compliance with IRS regulations.

Key Factors That Generate an NOL

A net operating loss typically results from a business downturn, but several factors contribute to it. A decline in revenue due to reduced sales, contract cancellations, or economic downturns is a common cause. A retail business facing lower consumer spending, for example, may struggle to cover fixed costs like rent and payroll, leading to a loss.

High operating expenses can also generate an NOL, particularly for capital-intensive businesses. Companies investing heavily in equipment, research, or expansion may incur significant depreciation and amortization expenses, reducing taxable income. A technology startup might spend millions on product development before generating substantial revenue, resulting in a loss that can be carried back to offset prior taxable income.

Unexpected costs, such as legal settlements, regulatory fines, or inventory write-downs, can further contribute to an NOL. A manufacturing company facing a product recall may absorb substantial costs for refunds and repairs, pushing expenses beyond revenue. Businesses with high interest expenses from debt financing may also see deductions exceed taxable income, especially if borrowing costs rise.

Timeframe for a Carryback Period

The ability to carry back an NOL depends on tax laws in place for the year the loss was incurred. The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated NOL carrybacks for most taxpayers, but the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 temporarily reinstated a five-year carryback for losses from tax years 2018, 2019, and 2020. That provision has since expired, meaning that as of 2024, businesses generally cannot carry back losses unless specific exceptions apply.

Certain industries, such as farming and insurance, still have the option to carry back NOLs for two years. Farmers can apply losses to prior returns to stabilize income fluctuations caused by unpredictable weather or market conditions. Insurance companies, particularly those dealing with property and casualty policies, retain this flexibility due to the long-tail nature of claim liabilities.

When a carryback is allowed, the loss is applied to the earliest eligible year first, then any remaining amount is carried forward. If a business incurs a $500,000 NOL and has taxable income of $300,000 in the first carryback year, the loss offsets that income entirely, and the remaining $200,000 is applied to the next earliest year. This method ensures taxpayers maximize refunds by utilizing losses against higher tax rates from previous years when applicable.

Required Documentation

Applying an NOL carryback requires submitting records to substantiate the loss and its application to prior tax years. The primary document is IRS Form 1045 (Application for Tentative Refund) for individuals, estates, and trusts, or Form 1120X (Amended U.S. Corporation Income Tax Return) for corporations. Form 1045 allows for a quicker refund process, while businesses typically use Form 1120X to amend prior returns. These forms must include detailed calculations showing how the loss was determined and applied.

Supporting schedules and financial statements validate the reported NOL. Taxpayers should provide income statements, balance sheets, and relevant schedules from the loss year to ensure deductions, credits, and taxable income are accurately reflected. If the loss includes depreciation or amortization expenses, attaching Form 4562 (Depreciation and Amortization) helps substantiate those deductions. Adjustments affecting tax credits, such as the general business credit (Form 3800) or foreign tax credit (Form 1116 for individuals, Form 1118 for corporations), should also be documented.

Maintaining records of prior-year tax returns verifies the available taxable income for offsetting the NOL. If the carryback affects multiple years, each impacted return must be reviewed and adjusted. Taxpayers should also retain documentation of any prior NOLs carried forward or back, as these could affect the allowable deduction for the current loss year.

How to Complete Amended Returns

Filing an amended return to apply an NOL carryback requires recalculating prior-year tax liabilities. The process begins by identifying the tax year to which the loss will be applied and determining the impact on taxable income, deductions, and credits. Since an NOL carryback can affect multiple aspects of a return, each change must be carefully documented to avoid discrepancies that could trigger an IRS audit.

Once adjustments are calculated, taxpayers must file the appropriate amended return form. Individual filers use Form 1040-X (Amended U.S. Individual Income Tax Return), while corporations submit Form 1120-X. These forms require revised tax calculations and a clear explanation of the changes. The IRS expects filers to provide a concise statement detailing how the NOL was determined, how it was allocated across prior years, and any corresponding modifications to deductions, credits, or tax payments. If the carryback results in a refund, taxpayers should also confirm that prior refunds or credits applied to future tax years remain accurate.

Potential Adjustments to Tax Liability

Applying an NOL carryback can lead to several adjustments beyond reducing taxable income. Once the loss is applied to a prior year, it may impact deductions, tax credits, and alternative minimum tax (AMT) calculations. Since tax liability is recalculated based on the revised income, all related components of the return must be adjusted accordingly.

One common change involves recalculating tax credits. If the original return included credits limited by taxable income, such as the foreign tax credit or general business credit, these may need to be recomputed. A reduced taxable income could lower the available credit, requiring adjustments to carryovers or refunds. If the prior-year return was subject to AMT, the carryback could alter AMT calculations, potentially leading to a refund of previously paid AMT liabilities. Taxpayers should also reassess deductions that phase out based on income levels, such as the qualified business income deduction under Section 199A.

State Tax Considerations

While federal tax rules govern NOL carrybacks, state tax treatment varies. Some states conform to federal rules, allowing carrybacks under the same guidelines, while others disallow them entirely or impose their own limitations. Businesses operating in multiple states must analyze how each jurisdiction treats NOLs to ensure compliance and maximize potential refunds.

Certain states, such as California and Pennsylvania, do not permit NOL carrybacks, meaning taxpayers can only carry losses forward for state tax purposes. Others, like Illinois, allow limited carrybacks but impose restrictions on the number of years or the percentage of the loss that can be applied. Some states require separate filings for NOL adjustments, necessitating amended state returns even if the federal carryback is processed automatically. Understanding these differences is essential for businesses seeking to optimize their tax position across multiple jurisdictions.