The loss carry forward method of realizing tax relief is absolutely legal and rewards entrepreneurs for risking their wealth for future growth.
Think of how much more you can do with your money if you did not have to pay any tax next year? You would be about 16% to 45% wealthier based on your tax bracket and state of residency.
To help business owners stay in operation, the tax code allows a special tax deduction, known as loss carry-forward, when losses occur. A loss carry-forward is nothing more than a tax deduction that can be taken in a future year.
Net Operating Loss Carry-Forward
When a business owner’s expenses exceed the sales for the year, he is eligible to take what is known as a net operating loss carry-forward.
A net operating loss carry-forward allows you to write down future income tax liabilities by the amount of the loss in the current year.
According to 2010 tax laws:
- Losses can be accumulated if there are multiple years of loss
- These losses can be carried forward for up to 20 years
Capital Gain Carry-Forward
When an asset such as a stock is bought then sold for more than the purchase price, the seller earns what is known as a capital gain.
If it is sold for less than the purchase price, you have what is called a capital loss, and these losses can be carried forward just like net income losses.
Key differences from net operating losses:
- There is a $3,000 annual limit to the losses that can be carried forward
- Individuals can make use of these deductions for their capital losses
Loss Carry-Back
Tax carry-forward allows a reduction of tax liability for future taxes, but loss carry-back allows a company to reclaim money that they have already paid in taxes.
If losses were large, a company could carry back the loss for two years.
If you operate a small business, you may qualify for years of carry-back
How Does This All Work?
Step 1: Calculate Your Net Operating Loss
For most businesses, this will be easy; however, it is especially important to make sure you have kept nonbusiness losses separate from business losses.
Nonbusiness losses are generally not allowed to be carried over to the same extent as business losses.
Net operating loss can be calculated by simply subtracting business expenses from business revenues.
Example:
If your business earned $3,000 but lost $20,000, you would have a net operating loss of $17,000
Step 2: Calculate Your Allowed Net Operating Loss Carryover Deduction
This deduction is limited to the extent that it would exceed your tax burden. In other words, you can’t use your net operating loss deduction to force the IRS to pay you money.
Example:
If you have $17,000 of net operating loss to carry over to Year 2 and your total income for Year 2 was only $4,000, you will be limited to $4,000 in carryover losses for that year and will have to wait until future years to use up more of your allowable deduction.
Step 3: Claim the Deduction on Tax Forms
List the figure you wish to use from Step 2 as a negative number under “Other Income” on Form 1040 or 1040NR to take the net operating loss deduction.
Example:
If you were using a $4,000 deduction, you would list “- $4,000” under “Other Income.”
Frequently Asked Questions
What is a loss carry-forward and how does it help with taxes?
A loss carry-forward is a legal tax strategy that allows business owners to apply current year losses to offset future taxable income. This reduces future tax liabilities and supports long-term business sustainability.
How long can I carry forward a net operating loss?
According to tax laws as of 2010, net operating losses can be carried forward for up to 20 years. This enables business owners to gradually reduce taxable income over time until the loss is fully used.
Can individuals use capital loss carry-forwards too?
Yes, individuals can carry forward capital losses. However, the IRS allows only up to $3,000 in capital losses to be deducted per year, with the unused amount carried forward to subsequent years.
What is the difference between loss carry-forward and loss carry-back?
Loss carry-forward applies losses to future tax years to reduce upcoming liabilities, while loss carry-back applies losses to past tax years, potentially resulting in a tax refund from previously paid taxes.
How do I claim a net operating loss deduction on my tax return?
To claim the deduction, calculate your allowed carryover based on your net operating loss and current income. Then, report it as a negative number under “Other Income” on IRS Form 1040 or 1040NR.