Net Operating Loss Rules Under Revenue Code 172
A business loss can provide future tax relief, but the usable net operating loss is a distinct figure governed by specific rules on its calculation and application.
A net operating loss provides a mechanism for taxpayers to utilize the financial loss from one year to lower their taxable income in a different year. This tax provision is designed for losses originating from the operation of a trade or business. When a business’s deductible expenses are greater than its taxable income, it results in a loss for that year. This provision allows individuals, C corporations, estates, and trusts to smooth out their tax liability over time, which is particularly helpful for businesses with fluctuating income cycles.
Calculating the Net Operating Loss
The calculation of a net operating loss (NOL) is a specific computation and is not simply the negative taxable income on a tax return. For noncorporate taxpayers like individuals, estates, and trusts, the first step is the “excess business loss” limitation. An excess business loss occurs when total business deductions are greater than the sum of total business income plus an annual threshold. For 2025, this threshold is $313,000 for single filers and $626,000 for joint filers. Any business loss above this limit is disallowed for the current year and is carried forward to the following year as a net operating loss.
After applying this limitation, further adjustments are needed to ensure the NOL reflects a true economic loss from business operations. The process requires adding back certain deductions not related to the business. A primary modification is adding back any NOL deduction from a prior year. Another adjustment is for the qualified business income (QBI) deduction, and individuals must also add back nonbusiness capital losses that exceed nonbusiness capital gains.
For example, a sole proprietor has a business loss of $70,000, which is below the excess business loss threshold. In computing the NOL, they must add back a $5,000 QBI deduction. They also had a $2,000 capital loss from personal investments but no personal capital gains, so this $2,000 must also be added back. The final NOL for the year would be $63,000.
Applying the NOL Deduction
Once an NOL is calculated, specific rules dictate how it can be used. For NOLs that arise in tax years beginning after 2020, carrybacks to prior tax years are not permitted. Instead, these losses are carried forward to future tax years indefinitely until the full amount is used.
The use of NOL carryforwards is subject to an 80% limitation. The NOL deduction is limited to 80% of the taxable income for the year to which the loss is carried, and this income figure is calculated before taking the NOL deduction. This rule prevents a taxpayer from completely eliminating tax liability in a profitable year using a prior-year loss.
For instance, a business has an NOL carryforward of $100,000. In the following year, it generates a taxable income of $90,000 before considering the NOL. The maximum NOL deduction allowed is $72,000 (80% of $90,000), which reduces the year’s taxable income to $18,000. The remaining $28,000 of the NOL is then carried forward to subsequent years.
Reporting the NOL on Tax Returns
Individual taxpayers report the NOL deduction on Schedule 1 of Form 1040 as a negative number under the “Other Income” section. For C corporations, the deduction is claimed on Form 1120, U.S. Corporation Income Tax Return. For any year an NOL deduction is claimed, the IRS requires taxpayers to attach a detailed statement to their tax return.
This statement must show the calculations used to determine the original NOL. It must also track the use of that NOL, detailing the amounts carried forward and deducted in each subsequent year. Taxpayers must maintain records for the loss year and all years the carryforward is applied to substantiate the deduction.