How to Handle a California Net Operating Loss
Navigate California's distinct net operating loss rules, which diverge from federal law and have specific limitations on offsetting future income.
When a business or individual’s deductible expenses surpass their income for a tax year, it results in a net operating loss (NOL). This situation allows taxpayers to use the loss from one year to reduce their taxable income in another. California has a distinct set of regulations governing NOLs, which differ from the rules set by the Internal Revenue Service (IRS) for federal tax purposes. These differences impact how a loss is calculated, carried over, and ultimately used.
California NOL Fundamentals
A California NOL can be generated by individuals, estates, trusts, and corporations when their business deductions exceed their business income. The state’s approach to NOLs diverges from federal tax law. A significant distinction is California’s rejection of NOL carryback provisions. For tax years beginning on or after January 1, 2019, California does not permit taxpayers to apply a current-year loss to a prior year’s tax return to generate a refund.
Instead, California NOLs can only be carried forward to offset future income. The starting point for calculating a California NOL also differs from the federal computation. California requires specific adjustments to account for differences between state and federal tax law, ensuring only deductions allowed under the California Revenue and Taxation Code are included.
The rules governing the use of an NOL can also vary depending on the tax year in which the loss was incurred. These foundational rules establish a separate framework for NOLs that requires careful attention to state-specific details, independent of federal tax considerations.
Calculating Your California NOL
The process of calculating a California NOL begins with the net loss on a taxpayer’s state return, but it requires several state-specific modifications. Individuals, estates, and trusts use Form FTB 3805V, while corporations use Form FTB 3805Q for the same purpose. These forms guide the taxpayer through a series of adjustments to the initial loss figure.
A primary adjustment involves adding back any federal NOL deduction claimed on the California return, as the federal deduction is not allowed for state purposes. Other common additions include capital gains deductions and certain non-business deductions. These items are added back to ensure the NOL is strictly related to business operations as defined by California law.
Conversely, certain items are subtracted from the loss figure. These subtractions include income from California sources that was not included in the federal adjusted gross income but is taxable in California. The form methodically walks through these additions and subtractions, resulting in the final California NOL figure for the tax year.
Completing the appropriate form, either FTB 3805V or FTB 3805Q, is also a record-keeping document. The form tracks the initial loss amount, the year it was incurred, and the type of NOL. This documentation is important for accurately applying the NOL carryover in future years and substantiating the deduction if the Franchise Tax Board (FTB) requests verification.
Applying the NOL Carryover
Once a California NOL is calculated, it can be carried forward to reduce taxable income in future years. For NOLs generated in tax years beginning on or after January 1, 2008, the carryover period is 20 years. The loss must be applied in chronological order, meaning older NOLs are used before more recent ones.
An aspect of applying an NOL in California is the percentage limitation. Unlike the federal system, California historically limited the deduction. Taxpayers must refer to the rules for the year the loss was generated to determine the applicable rate, meaning only a portion of an NOL carryover might be usable in any single tax year.
The application of NOLs has also been subject to temporary suspensions. A new suspension is in place for the 2024, 2025, and 2026 tax years. This suspension applies to individual and corporate taxpayers with net business income or modified adjusted gross income of $1 million or more.
These are suspensions of the deduction, not a forfeiture of the loss. The carryover period for any NOL deduction disallowed due to a suspension is extended. Taxpayers must continue to track their NOLs on forms FTB 3805V and FTB 3805Q during these periods, even if a deduction cannot be taken.
Claiming the NOL Deduction on Your Tax Return
After determining the allowable NOL carryover deduction for the current tax year, the final step is to report it correctly on the California income tax return. The deduction is transferred from the specific NOL computation form.
For individual taxpayers filing Form 540, the California Resident Income Tax Return, the NOL deduction is reported on Schedule CA (540), California Adjustments. The allowable NOL deduction is entered as a subtraction, reducing the amount of income subject to California tax.
Corporations filing Form 100, California Corporation Franchise or Income Tax Return, will report their NOL deduction on a specific line designated for this purpose. The amount entered must match the allowable deduction calculated on Form FTB 3805Q.
For both individuals and corporations, it is necessary to complete and attach the relevant NOL form—FTB 3805V for individuals or FTB 3805Q for corporations—to the tax return. This form substantiates the amount of the deduction being claimed and shows the history of the NOL.