Small businesses have been adversely impacted by the continuing global financial crisis. Many cannot pay their bills currently and have been forced to lay off employees due to lack of funds. Many will experience net operating losses (NOLs) for 2008. If handled properly, a 2008 net operating loss can generate tax refunds for 2006 and 2007. The tax refunds can help alleviate the shortfall in 2008, making it more likely that the business will be able to survive the downturn.

 

 

The federal income tax is imposed on a taxpayer's taxable income, which is its gross income reduced by the allowable deductions. When the deductions exceed the gross income, however, the taxpayer has sustained a NOL. Thus, if gross income is $100 and the allowable deductions total $60, the taxpayer must pay tax on its taxable income of $40. If, however, the gross income is $60 and the allowable deductions are $100, the taxpayer has a net operating loss of $40.

 

To keep a taxpayer from losing the benefit of excess deductions in one taxable year, a net operating loss can be used to reduce taxable income in prior and future taxable years. Specifically, a net operating loss can be deducted in the two previous years and in the 20 following years. When a net operating loss is deducted in a prior taxable year, the taxpayer is entitled to a refund of the excess taxes created by the deduction. When there is a carryover, taxable income in future years is reduced.

 

 

For a taxpayer in financial trouble, the deduction of a NOL and the resulting refund can represent a lifeline for weathering the financial crisis. The carryback period is two years in most cases. Thus, a 2008 net operating loss can be carried back to 2006 and 2007. The taxable income for 2006 and 2007 has to be recalculated to reflect the net operating loss deduction. If the 2008 net operating loss exceeds the 2006 taxable income, the business will be entitled to a refund of all the taxes paid in 2006. The refund provides liquidity to meet payroll and expenses.

 

 

If a business did not have any taxable income in the carryback years, a NOL deduction is still available, but it will bring a future benefit. The twenty-year carryover period gives most taxpayers enough time to take full advantage of a deductible loss. The carryback period for a 2008 net operating loss runs from 2009 to 2028. Thus, a 2008 net operating loss gets deducted on a taxpayer's 2009 return, which is not due until March or April of 2010.

 

 

Businesses are operated for the purpose of earning a profit, so ending a year with a loss is discouraging. While it may seem like small comfort, the net operating loss can be carried back to generate a tax refund. The strategy of getting immediate cash from a net operating loss does not work, however, if the business broke even or experienced net operating losses in the carryback years.

 

 

Freitag, Tax Management Portfolio 539, Net Operating Losses – Concepts and Computations