Net Operating Loss (NOL) Rules: IRC Section 172 for CPA Candidates
Master the net operating loss rules under IRC Section 172 for the CPA REG exam. Covers NOL computation, carryforward rules, the 80% limitation, and special rules for farming losses.
Net Operating Loss Rules Under IRC Section 172
A net operating loss (NOL) occurs when a taxpayer's allowable deductions exceed gross income for a taxable year. The NOL provisions under Section 172 allow taxpayers to use these losses to offset income in other years, providing relief for cyclical income patterns. The Tax Cuts and Jobs Act (TCJA) of 2017 significantly changed the NOL rules, and CPA candidates must understand both the current framework and the transition rules.
Computing the NOL
Individual Taxpayers
For individual taxpayers, the NOL is computed by starting with taxable income (a negative number) and making several modifications. The following items are added back (i.e., they cannot contribute to or increase the NOL): the standard deduction or itemized deductions (with certain adjustments), personal exemptions (prior to TCJA suspension), capital losses in excess of capital gains, the Section 1202 exclusion for qualified small business stock, and nonbusiness deductions in excess of nonbusiness income.
Business deductions, including deductions from Schedule C, rental activities, and the employee business expense deductions (when applicable), can generate or contribute to an NOL. Investment losses from passive activities are subject to passive activity loss rules before they can contribute to an NOL.
Corporate Taxpayers
For corporations, the NOL computation is more straightforward. A corporation's NOL is generally its negative taxable income with certain modifications, including the dividends-received deduction and any carryback or carryforward from other years. Corporations cannot use capital losses to create an NOL; capital losses can only offset capital gains.
Carryforward Rules Under Current Law
Post-2017 NOLs
For NOLs arising in tax years beginning after December 31, 2017, the TCJA eliminated the two-year carryback and replaced it with an indefinite carryforward. These NOLs can be carried forward indefinitely but are limited to 80% of taxable income (computed without regard to the NOL deduction) in any carryforward year. This means that at least 20% of taxable income is always subject to tax when post-2017 NOLs are used.
Pre-2018 NOLs
NOLs arising in tax years beginning before January 1, 2018, could be carried back two years and forward 20 years. These pre-2018 NOLs are not subject to the 80% limitation when used; they can offset 100% of taxable income. Pre-2018 NOLs are used before post-2017 NOLs.
Special Carryback Provisions
Certain types of losses retain carryback eligibility even under current law. Farming losses (as defined in Section 461(j)) may be carried back two years. Qualified disaster losses may also have special carryback provisions depending on the applicable legislation. Insurance companies have their own NOL rules under Section 810.
The 80% Limitation in Practice
The 80% limitation can create unexpected tax liabilities. For example, a corporation has $1,000,000 in taxable income (before the NOL deduction) and a $1,200,000 NOL carryforward from 2019. The NOL deduction is limited to $800,000 (80% of $1,000,000). The corporation pays tax on $200,000, and the remaining $400,000 NOL carries forward to the next year.
When both pre-2018 and post-2017 NOLs exist, the pre-2018 NOLs are applied first without the 80% limitation. Only after the pre-2018 NOLs are exhausted does the 80% limitation apply to the remaining post-2017 NOLs.
NOLs and Business Structures
- C corporations: The NOL stays with the corporation. Ownership changes exceeding 50% may trigger Section 382 limitations on the annual use of pre-change NOLs.
- S corporations: Losses pass through to shareholders and are subject to basis, at-risk, passive activity, and excess business loss limitations at the shareholder level. There is no NOL at the entity level.
- Partnerships: Similar to S corporations, losses pass through to partners and are subject to multiple limitation layers at the partner level.
Excess Business Loss Limitation
Under Section 461(l), noncorporate taxpayers cannot deduct aggregate business losses exceeding $305,000 (single) or $610,000 (married filing jointly) for 2024, indexed for inflation. Excess business losses are treated as an NOL carryforward subject to the 80% limitation in subsequent years.
CPA Exam Strategies
- Know the modifications required to compute an individual NOL (add back nonbusiness deductions exceeding nonbusiness income, standard/itemized deductions, etc.).
- Distinguish pre-2018 NOLs (100% offset, 20-year carryforward) from post-2017 NOLs (80% limitation, indefinite carryforward).
- Remember that farming losses retain a two-year carryback.
- The 80% limitation applies to taxable income computed without the NOL deduction itself.
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