Net Operating Loss (NOL): Definition, Rules, and How It Works

Key takeaways
* A net operating loss (NOL) occurs when allowable business deductions exceed taxable income for a tax period.
* NOLs can be carried forward indefinitely but generally may offset only up to 80% of taxable income in a given year.
* Carrybacks are mostly eliminated (with limited exceptions such as certain farming losses); temporary CARES Act rules briefly changed this for 2018–2020.
* NOLs are recorded as deferred tax assets and can be subject to additional limits after ownership changes or for noncorporate taxpayers.

What is an NOL?

An NOL arises when a company’s tax deductions exceed its taxable income for a tax year. Common causes include startup losses, capital-intensive investments, and cyclical declines in revenue. Rather than losing the tax benefit entirely, tax rules allow businesses to use NOLs to reduce tax in other years through carryforwards (and, historically, sometimes carrybacks).

Core carryforward rules

• Indefinite carryforward: NOLs can be carried forward without a statutory time limit.
• 80% limitation: For tax years beginning after 2020, NOL deductions generally cannot reduce taxable income by more than 80% in a single year.
• No general carrybacks: Carrybacks are generally disallowed, though limited exceptions (e.g., some farming losses) still permit carrybacks.
• Two-tier treatment: NOLs originating from tax years beginning before 2018 are treated differently from those arising after 2017; pre-2018 NOLs can offset 100% of taxable income, while post-2017 NOLs are subject to the 80% cap.
• Excess business loss limitation (noncorporate taxpayers): For 2021–2028, excess business losses for individuals, estates, and trusts are disallowed and treated as NOL carryforwards. Thresholds adjust annually (for 2024, the threshold was $305,000 for single filers and $610,000 for joint filers).

How these rules affect businesses
* Cash flow: With limited or no carrybacks, companies cannot generally claim immediate refunds for recent losses and must plan cash flow accordingly.
* Tax planning: Indefinite carryforwards let profitable years absorb past losses over time, but the 80% cap and sourcing-year distinctions complicate planning.
* Accounting: NOLs typically appear as deferred tax assets on the balance sheet, subject to valuation allowances if recovery is uncertain.

How to calculate an NOL (basic steps)
1. Start with taxable income (or loss) before applying any NOL deduction for the current year.
2. Add back NOL carryovers from other years (they don’t factor into the current-year NOL computation).
3. Exclude nonbusiness deductions that exceed nonbusiness income.
4. Exclude net capital losses in excess of capital gains.
5. Remove any Section 1202 exclusion for qualified small business stock (if applicable).

Individuals, estates, and trusts typically use IRS worksheets (e.g., Publication 536) to compute an NOL, while corporations follow similar adjustments under corporate rules.

Historical context (brief)
* Pre-2017: NOLs could generally be carried back two years and forward twenty years.
TCJA (2017): Eliminated most carrybacks, allowed indefinite carryforwards, and limited NOLs to 80% of taxable income.
CARES Act (2020): Temporarily allowed five-year carrybacks for certain 2018–2020 NOLs and suspended the 80% limit for tax years beginning before 2021. After that relief period, TCJA-style limits resumed (with the current indefinite carryforward and 80% cap).

Restrictions after ownership changes (Section 382)

When a corporation undergoes an ownership change (generally defined as a more-than-50% increase in ownership by 5% shareholders over a three-year period), Internal Revenue Code Section 382 can greatly limit the annual use of pre-change NOLs. The annual limit is roughly the value of the loss corporation immediately before the ownership change multiplied by the long‑term tax-exempt rate. Example: a $1 million company with a 5% applicable rate would be limited to using about $50,000 of pre-change NOLs per year.

Illustrative example

Daratech Solutions:
* Year 1: NOL of $500,000.
* Year 2: Taxable income of $400,000.

Application:
* Maximum NOL deduction in Year 2 = 80% of $400,000 = $320,000.
Taxable income after NOL deduction = $400,000 − $320,000 = $80,000.
Remaining carryforward = $500,000 − $320,000 = $180,000 (carried forward indefinitely, subject to the same limits).

Bottom line

An NOL is an important tax provision that lets businesses turn a loss year into future tax relief through carryforwards. Recent law changes created an indefinite carryforward but also introduced an 80% annual limitation and other special rules (including restrictions after ownership changes and limits for noncorporate taxpayers). Effective tax and cash-flow planning requires careful tracking of NOL origination years and attention to applicable caps and exceptions.