The 80% NOL Limitation With a Calculation Example

A net operating loss, or NOL, occurs when a company’s tax-deductible expenses are greater than its revenues during a tax year. This results in negative taxable income, meaning no income tax is due for that period. Businesses can use these losses to lower their taxable income in subsequent profitable years. Federal tax laws, however, place certain restrictions on how much of this loss can be applied against future profits.

The 80% NOL Limitation Rule

The Tax Cuts and Jobs Act of 2017 (TCJA) changed how businesses can use net operating losses. For NOLs that originate in tax years beginning after December 31, 2017, the amount of the loss that can be deducted in a future year is restricted. The NOL deduction is limited to 80% of the taxable income for the year in which the deduction is taken. The calculation of this 80% limit is based on taxable income before the NOL deduction itself is applied.

This change marked a departure from previous regulations. Before the TCJA, businesses could use an NOL to offset 100% of their taxable income in a given year. The introduction of the 80% limitation means that even if a company has a substantial NOL from a prior year, it may still have a tax liability on 20% of its income.

The rule was temporarily suspended by the Coronavirus Aid, Relief, and Economic Security (CARES) Act for tax years 2018, 2019, and 2020, but it was reinstated for tax years starting in 2021. A company might show a cumulative loss over several years but still face a tax liability in its first profitable year due to this rule. The unused portion of the NOL is not lost but carried forward to subsequent years.

Calculating the NOL Deduction

The process involves determining the available loss, calculating the annual limitation based on income, and then applying the lesser of the two amounts to find the final taxable income.

Imagine a company, Innovate Corp., which is in its initial development phase. In its first year of operations, Year 1, it incurs significant startup costs without generating substantial revenue. The company’s financial records for Year 1 show total revenues of $200,000 but tax-deductible expenses of $700,000. This results in a net operating loss of $500,000 for the year ($200,000 – $700,000). This $500,000 NOL is now available to be carried forward to offset future income.

In Year 2, Innovate Corp.’s business gains traction, and it becomes profitable. The company generates $300,000 in taxable income before considering any NOL deduction from the prior year. Under the rules established by the TCJA, the company cannot use its entire $500,000 NOL to wipe out this income. Instead, it must first calculate the 80% limitation for Year 2. This is found by taking 80% of its taxable income: 80% of $300,000 equals $240,000.

The allowable NOL deduction for Year 2 is the lesser of the total NOL available ($500,000) or the 80% limitation ($240,000). This amount is then subtracted from the initial taxable income to determine the final figure on which tax is owed. The calculation is $300,000 (Initial Income) minus $240,000 (NOL Deduction), which results in a final taxable income of $60,000 for Year 2.

After applying the deduction, a portion of the original NOL remains. To calculate the remaining NOL carryforward, the amount used in Year 2 is subtracted from the original NOL. This would be $500,000 minus $240,000, leaving $260,000. This remaining NOL is carried forward to be used against income in future years, subject to the same 80% limitation.

Treatment of Pre-2018 NOLs

Net operating losses from different periods are subject to different rules. NOLs that arose in tax years beginning before January 1, 2018, are not subject to the 80% taxable income limitation. These older losses retain the ability to offset 100% of taxable income.

A specific ordering rule applies when a business possesses both pre-2018 and post-2017 NOLs. The tax code requires that the pre-2018 NOLs must be used first, before any of the newer, limitation-bound NOLs are applied. This allows a company to exhaust its more flexible loss assets first.

For example, consider a business with $50,000 of NOLs from the 2017 tax year and a large NOL from 2021. If this business has $200,000 of taxable income, it would first apply the full $50,000 of the pre-2018 NOL. This reduces the taxable income to $150,000. After the pre-2018 loss is fully used, the company would then apply its post-2017 NOL, subject to the 80% limitation calculated on the remaining $150,000 of income.

NOL Carryforward Mechanics

The Tax Cuts and Jobs Act also altered the rules governing how long and in which direction net operating losses can be carried. For NOLs arising in tax years beginning after December 31, 2017, the law introduced two primary changes to these mechanics.

Newer NOLs can be carried forward indefinitely. This removes the previous 20-year limit on carryforwards, providing businesses a much longer timeframe to utilize their losses against future profits. This provision ensures that the value of the NOL is not lost simply due to the passage of time, which is particularly beneficial for cyclical industries or startups that may take many years to achieve consistent profitability.

The ability to carry an NOL back to previous tax years was eliminated for most taxpayers. Before the TCJA, businesses could carry a loss back two years to receive an immediate refund of taxes paid in those prior, profitable years. While the carryback provision was temporarily reinstated by the CARES Act for certain years, post-2017 NOLs can only be carried forward. Limited exceptions to this rule exist for specific industries, such as certain farming businesses and non-life insurance companies, which may retain limited carryback options.