How to File for Net Operating Losses

“Do I really need to file a tax return? I lost money this year on my business.” I hear this question quite often, usually from a despondent business owner who can’t afford my tax preparation fee and doesn’t want to prep the books and come to grips with the depressing sales numbers.

The answer of course is yes, you must file. If you are self-employed and your gross receipts for the year exceed $400, the IRS says you must file.

But there is an even better reason to file, one with a financial payoff:  You may be able to take a Net Operating Loss (NOL), which can be carried back to secure refunds from tax returns filed in previous years. Or you can elect to carry forward the loss to reduce taxable income in the future and reduce future tax liabilities.

One of the first tax returns I completed for a client involved a net operating loss. He brought in his prior three years tax returns all of which showed losses. I felt bad for the guy. He was living in the loft of his auto repair shop, flat broke and feeling depressed because he just couldn’t seem to get things right. He was finally starting to make some money and worried that he wouldn’t be able to pay current year taxes.

I did a little research and found out that the losses declared on the prior three years had not been used at all, so I carried back the losses and was able to secure refunds for him of close to $4,000. That was a lot of money back in the 1980s. My client had no clue that this was available to help him and his small business and told me “I thought those losses were just water under the bridge.”

While a loss from operating a business is the most common reason for an NOL, other causes can trigger filing for it, including: casualty and theft loss, disaster losses, excess employee business expenses, moving expenses, or loss from a rental property.

Most of the time, a business loss is used to reduce current year income. But if your only source of income is from the business, an NOL is created that can be used in prior or subsequent tax years. This is another reason the IRS looks carefully at a sequence of losses from a business with an eye to reclassifying the business as a hobby. The agency doesn’t want to shell out those refunds without good cause.

To figure an NOL, use IRS Form 1045. Complete instructions and examples are available in IRS Publication 536. However, it is usually prudent to have a tax pro do the calculations because it can be a little tricky. Once you have determined the amount of the loss, you may apply the NOL to prior years, and any excess can be carried forward for 20 years. Or rather than carry back the losses, you can make an election to carry forward the NOL to future years. But once you waive the carry back period, it is generally irrevocable.

Partnerships and S Corporations pass through their losses to the partners and shareholders to use on their individual income tax returns.

A C Corporation can sustain a loss and carry it back or elect to carry it forward 20 years. Just make sure the carryover is listed on Schedule K. A special rule for C Corporations allows an extension of time for paying taxes due on the prior year if the corporation is expecting an NOL in the current year. Simply file IRS Form 1138 Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback.  The payment of tax postponed cannot exceed the amount expected from the carryback.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.