Tax season is cooooomiiiing! At this point, you should have a pretty good idea of how your business is performing, and specifically whether you'll end the year profitable or... not.
It's important to talk about those tough years when your business has a Net Operating Loss (NOL)—when it loses money. With the proper tax planning, you can use some tax judo to mitigate the monetary loss of your business by offsetting it with tax savings. This can take the form of a refund of prior year taxes paid, or an offsetting of future taxes owed. [If you know your business will be profitable this year, check out our article, Tax Tips: Writing Off Asset Purchases, which talks about strategies to decrease your tax liability.]
When you are growing a new business, it is common to start off with a few years of losses. Even more established businesses, no matter how well they’re run, fall on hard times. Macroeconomic, environmental, or political factors can all have an adverse effect on a business, and these can be difficult for an owner to predict and impossible for them to control. Small/midsize business owners can buy insurance to protect themselves from some environmental factors, but some things, like a housing crisis, can't be underwritten.
How can I see any positive in a loss year?
If your business does have an NOL, there is a silver lining. Your business can utilize it by:
- Carrying it back up to two years - meaning you apply the loss to a previous year’s taxes, and receive a rebate on any taxes you paid on profit you earned in those years.
- Carrying it forward up to twenty years - meaning any year you are profitable for the next 20 years, you can use this loss to offset your tax burden. After 20 years, however, the NOL is canceled and can no longer be utilized.
Let's look at an example to further clarify. Amber's Construction Company (ACC) was established in 2006 and they posted profits of $70,000 in their first year. 2007 went well for ACC until the financial crisis, at which point their profit took a major hit, sinking to just 10,000. In 2008 and 2009, ACC posted losses of $50,000 and $20,000, respectively. According to NOL limitation rules, the 2008 losses can be carried back two years in order to offset $50,000 of the $70,000 in profit from that year, as per the figure below.
The 2009 loss can only go back to the 2007 tax year in order to offset that income. ACC can then carry the remaining $10,000 loss forward up to twenty years as a reduction to any taxable income, asdepicted below:
Note: You can carry multiple loss years to the same year if that year satisfies the 2 years back/20 years forward rule.
As a result of the tax rebates from carrying losses back, ACC will see a “savings,” of $9,000, assuming a tax rate of 15%, and a potential future tax savings of $1,500 in the year they decide to utilize the loss. These are calculated as follows:As you can see from the example, the loss is mitigated by the fact that there is an ability to recoup previous taxes paid. But, please note that you will have to refile tax returns for the years you are carrying back losses in order to recoup the $9,000 from the example above.
Why would I want a refund of prior year taxes rather than use that savings for a future? tax year?
This all has to do with the economic concept of the Time Value of Money. The general idea is that a dollar today is worth more than a dollar 2 months from now, because you can put the dollar today to use where it has earning capacity.
For a simple example, let’s say your good friend offers to give you a loan for your business. She is willing to give you either $10,000 today, or $12,000 on this day next year. Most people would say they want the $10,000, and they would probably be right. The reason being that the $10,000 today can be put to use immediately in helping your business generate sales. Whether it is through helping you fund a new asset purchase, or hiring a new employee, you have a year to employ those resources. Generally, you should be able to earn at least a 3% rate of return on your money (leaving you with 13,000 at the end of the year) in the market if you just invested it, so it wouldn’t really make much sense to wait the year.
So if we recognize that money today has more value to us than money a year from now, it makes the most sense (if possible) to look back and get a refund on taxes paid in prior years, so that you can use that money to invest in your business today.
Where can I go for more information?
This is NOT a comprehensive review of all things NOL. If you are looking for more detail on the specifics of carrying losses forward and back, here is a link to the IRS publication on the topic. Or, talk to your trusted tax advisor. Don't have a trusted tax advisor? Talk to one of Paro's finance experts.