Net Operating Loss

As a result of COVID-19 and the unexpected shut down of the national economy, 2020 will likely result in net operating losses for many businesses and individuals through no fault of their own. But what does a net operating loss as defined by the Internal Revenue Service mean for you and your business?

What is a Net Operating Loss?

The Internal Revenue Code defines a Net Operating Loss (NOL) as the deductions allowed minus gross income. One part of the deductions allowed is the taxpayer’s share of the business loss. The net operating loss permits deductions allowed under the tax code to be netted against the business income and nonbusiness income.

Under § 172 of the Code, if the taxpayer has an NOL it can be used as an NOL deduction, which can be carried back or carried forward and used to offset taxable income in the carryback or carryforward year.

An NOL may be present when the taxpayer’s deductions exceed his adjusted gross income and result in a negative taxable income. Typically, an NOL results from losses from a taxpayer’s trade or business.

How a Net Operating Loss Works

Net loss is a product of a business’s expenses exceeding their source of income in the taxable year and is subject to the at-risk and passive activity loss limitations according to the IRS 2019 Instructions for Schedule C.

The net losses from the taxpayer’s business during the taxable year will have to be reported by filing a Schedule C. According to the Internal Revenue Code, when filing taxes for the year an individual or business must determine whether they have taxable income as defined by § 63 of the Code. The Code defines taxable income as gross income minus the deductions allowed.

If a taxpayer has a negative taxable income, the taxpayer may have an NOL as a result of the deductions allowed exceeding the taxpayer’s adjusted gross income. Ultimately, a business’s operating loss is just one part of the taxpayer’s potential NOL.

Small Business Owners affected by Corona Virus

Limits and Calculating Net Operating Losses

The limits on NOL include capital losses in excess of capital gains and nonbusiness deductions in excess of nonbusiness income among other items.

In calculating an NOL, an individual taxpayer needs to engage in a detailed analysis by distinguishing business deductions from nonbusiness deductions and business income from nonbusiness income.

Non-Business Deductions

  1.  alimony paid,
  2. deductions for contributions to an individual retirement account (IRA) or a self-employed retirement plan
  3. health savings account deduction
  4. Archer medical savings account deduction
  5. most itemized deductions (except for casualty and theft losses resulting from a federally declared disaster and state income tax on trade or business income)
  6. the standard deduction.

Business Deductions

Business deductions include but are not limited to

  1. losses relating to the trade or business or an individual’s partnership or S corporation share of the losses,
  2. a business using the accrual accounting method with losses on the sale of accounts receivable,
  3. state income tax on income from your trade or business (including wages, salary, and unemployment compensation),
  4. rental losses,
  5. loss on the sale or exchange of business real estate or depreciable property

Business Income

  1. salaries and wages,
  2. self-employment income,
  3. unemployment compensation
  4. rental income
  5. ordinary gain from the sale or other disposition of business real estate or depreciable business property
  6. your share of business income from a partnership or an S corporation.

Non-Business Income

  1.  taxable IRA distributions,
  2. pension benefits,
  3. social security benefits
  4. annuity income,
  5. dividends
  6. interest on investments,
  7. share of nonbusiness income from a partnership or an S corporation.

All of the above information plays a significant role when determining the amount of an NOL and the taxable income of the taxpayer. If you have additional questions about a net operating loss and how it applies to you, contact The May Firm today.

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