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A net operating loss is the amount by which a business's allowable tax deductions exceed its gross income for the year. It signals that your operations generated more costs than revenue, creating a tax-recognized loss you can use to offset taxable income in other years. The IRS allows this deduction under Section 172 of the Internal Revenue Code.
The purpose is to level the playing field between businesses with smooth year-over-year profits and those with volatile income cycles. A startup burning cash in year one and turning profitable in year three should not pay taxes as if those early losses never happened.
You generate an NOL when your business deductions exceed gross income. Once that loss is recognized, you have two options: carry it back to offset income in prior years (generating a refund) or carry it forward to reduce taxable income in future profitable years.
Under current law following the Tax Cuts and Jobs Act of 2017, most businesses cannot carry NOLs back at all. Farmers are the primary exception, with a two-year carryback allowed. For everyone else, the loss carries forward indefinitely.
This is the rule that catches most business owners off guard. When you use a carryforward NOL to offset income, you can only eliminate up to 80% of your taxable income for that year. You must still pay taxes on at least 20%.
Here is how it works in practice: if you carry a $200,000 NOL into a year where you earn $150,000, you can deduct only $120,000 (80% of $150,000), not the full $150,000. You still owe tax on the remaining $30,000. The unused $80,000 of your NOL carries forward to the next year.
Corporations, individuals, estates, and trusts can all generate and deduct NOLs, though the mechanics differ. Pass-through entities like partnerships and S corporations do not claim the NOL deduction at the entity level. Instead, losses pass through to the individual owners, who apply them on their personal returns subject to passive activity and basis limitation rules.
To qualify as an NOL for deduction purposes, the loss must generally come from operating a trade or business, owning rental property, or a casualty or theft loss from a qualified disaster. Personal expenses and investment losses follow different rules.
The old system allowed carrybacks, which generated immediate cash through tax refunds. That era is over for most businesses. The current system forces you to treat an NOL as a long-term asset, a deduction you will use across future profitable years rather than a tool to reclaim past taxes quickly.
This changes cash flow planning significantly. A loss year no longer guarantees a refund check. You need to project your future taxable income and model how quickly you can absorb the NOL carryforward within the 80% annual limit.
States set their own NOL rules and many do not conform to federal law. California suspended NOL deductions through 2026 for taxpayers with net business income exceeding $1 million. Minnesota limits the deduction to 70% of income. Rhode Island extended its carryover period from five to 20 years for tax years beginning January 1, 2025. If you operate across multiple states, you are managing different NOL rules in each jurisdiction simultaneously.
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