What Is the California NOL Suspension?

A net operating loss, or NOL, allows a business or individual to use a loss from one year to reduce taxable income in a future year. This provision helps to average out profitability over time, as business operations can fluctuate between profitable and unprofitable periods. California law permits taxpayers to carry these losses forward to offset future income. However, the state enacted legislation that temporarily altered the ability of some taxpayers to use these deductions.

The NOL Suspension Period

In June 2020, California passed Assembly Bill 85, which introduced a temporary suspension of net operating loss deductions. This measure was enacted to increase state revenue and applied to the 2020 and 2021 tax years. The suspension was not universal; it specifically targeted taxpayers with higher incomes. It applied to corporations and individuals whose net business income or modified adjusted gross income was $1 million or more.

The suspension impacted a wide range of taxpayers, including C corporations, sole proprietors, and owners of pass-through entities like S corporations and partnerships. If a taxpayer’s income met or exceeded the $1 million threshold in either of the suspension years, their ability to use NOL carryforwards to reduce their California taxable income was disallowed for that year.

This legislation also placed a temporary cap on the use of most business tax credits. During the same 2020 and 2021 tax years, a taxpayer could not use business credits to reduce their tax liability by more than $5 million annually. This limitation applied to many popular credits, such as the research and development (R&D) credit. For businesses that file as part of a combined group, this $5 million cap applied to the entire group, not to each individual entity.

Extended Carryover for Suspended Losses

While the suspension disallowed the use of NOLs for two years, the losses themselves were not forfeited. To compensate taxpayers for the temporary inability to use these deductions, the state provided a corresponding extension to the carryover period. The length of the extension is directly tied to the year the loss was generated and when it was suspended.

For an NOL that was incurred before the 2020 tax year, its carryover period is extended by the number of years its use was disallowed because of the suspension. For example, if a loss from 2019 could not be used in 2020 and 2021 due to the taxpayer’s income exceeding the $1 million threshold in both years, its carryover period would be extended by two years.

The rules provide specific extension periods for losses that were generated during the suspension period itself. An NOL incurred in the 2020 tax year receives a two-year carryover extension. Similarly, an NOL from the 2021 tax year is granted a one-year extension. These extensions are automatic for any NOL whose deduction was denied due to the suspension rules.

Calculating and Applying California NOLs Post-Suspension

With the suspension period having concluded, taxpayers could resume using their NOLs to reduce California income starting with the 2022 tax year. The state’s NOL rules allow for a 20-year carryover period and, unlike federal rules, do not permit carrybacks to prior tax years for most NOLs. The key to correctly applying these losses now involves careful tracking and calculation, accounting for both the original loss amounts and the newly extended carryover periods.

The primary tool for this process is California Form 3805V, Net Operating Loss (NOL) Computation and NOL and Disaster Loss Limitations. It serves as a worksheet to track the history of each NOL, including the year it was generated, the original amount, any portion used in years prior to the suspension, and the remaining balance available for use.

The form guides the calculation of the current year’s allowable NOL deduction by sequencing the use of older losses first. Taxpayers list their available NOLs from earliest to latest, apply the income limitations, and determine the amount that can be used on their current tax return, such as Form 540 for individuals or Form 100 for corporations.

For instance, a 2019 NOL that was suspended for two years will now have an expiration date two years later than its original 20-year lifespan would have dictated. Accurately tracking these adjusted dates on Form 3805V is necessary to maximize the use of available losses before they expire and to ensure compliance with state tax law.