Why Do Net Operating Losses Matter for Business Owners?

Running a business means dealing with uncertainty. A slow year, a large equipment purchase, an unexpected expense, a startup ramp-up phase, all of these can produce a year in which your deductible business expenses exceed your business income. That gap is not just a bad result to write off and forget. In many situations, it can reduce your taxes in future profitable years.

This is what the net operating loss rules are designed to do: allow taxpayers who experience a genuine economic loss in one year to use that loss to offset taxable income in other years. Over more than 15 years working with taxes, accounting, finance, and business owners in multiple industries, I have seen many clients overlook this opportunity, often because they assume a loss year is simply a loss and nothing more can be done.

That assumption can be costly. Properly tracking, calculating, and carrying forward an NOL is a legitimate part of tax planning that every business owner with fluctuating income should understand.

What Is a Net Operating Loss and How Is It Calculated?

A net operating loss, at the federal level, is generally defined as the amount by which a taxpayer's allowable deductions exceed their gross income for the tax year, after applying specific modifications required by the Internal Revenue Code. This is not simply the same as a negative number on one line of your tax return.

The IRS requires that you complete a formal NOL calculation. The modifications involved in that calculation depend on your situation, but commonly include:

• Removing personal exemptions (which are currently suspended for tax years 2018 through 2025 under the Tax Cuts and Jobs Act)
• Adding back capital loss deductions that exceed capital gains
• Adding back the NOL deduction itself if you claimed one from a prior year
• Applying the excess business loss limitation rules under IRC Section 461(l) for non-corporate taxpayers (discussed below)

Because of these modifications, working with a tax professional to calculate an NOL accurately is strongly recommended. An incorrectly calculated NOL, whether too large or too small, can create problems in the year the loss is claimed and in every future year the carryforward is used.

Who May Qualify to Use an NOL Deduction?

Individuals, C corporations, estates, and trusts can each generate and use an NOL under federal tax law, though the specific rules differ by entity type. The situations most relevant to the clients I work with include:

Sole Proprietors and Schedule C Filers

If you operate a business and report income and expenses on Schedule C, a loss from that business flows to your Form 1040. If that loss, combined with your other income and deductions for the year, results in a negative taxable income after the required modifications, you may have an NOL to carry forward to future tax years.

Self-Employed Individuals

Independent contractors, freelancers, and gig economy workers who report income on Schedule C face the same analysis. If allowable business deductions exceed business income, and the net loss is large enough to push overall adjusted gross income below zero after modifications, an NOL may result.

S Corporation Shareholders

An S corporation does not pay federal income tax at the entity level. Instead, income and losses pass through to shareholders proportionately. If an S corporation generates a loss in a tax year, each shareholder's share of that loss flows through to their individual return. However, a shareholder may only deduct a loss up to the amount of their adjusted stock basis plus any debt basis. Losses in excess of basis are suspended, not lost, and may be deducted in a future year when the shareholder restores basis. Whether a flow-through loss from an S corporation contributes to an NOL at the individual level depends on the shareholder's complete tax picture for the year.

LLC Owners

The tax treatment of an LLC depends on how it is classified for federal tax purposes. A single-member LLC disregarded as a separate entity is treated like a sole proprietorship for income tax purposes. A multi-member LLC treated as a partnership has losses flow through to partners. An LLC that has elected to be treated as an S corporation or C corporation follows those rules. The applicable NOL rules follow the federal tax classification of the entity.

Real Estate Investors and Short-Term Rental Owners

Real estate investors often generate large deductions, such as depreciation, mortgage interest, repairs, and professional fees, that can exceed rental income. The ability to use those losses is heavily dependent on the passive activity loss rules under IRC Section 469, the at-risk rules under IRC Section 465, and, for short-term rentals, how the activity is classified. Rental losses that are passive losses generally cannot create or increase an NOL unless they are deductible in the current year, which requires meeting specific criteria such as the real estate professional status rules or the active participation exception for lower-income taxpayers. If you are a real estate investor, this is an area that warrants careful analysis.

Who May Not Qualify or Face Significant Limitations?

The following limitations are important for non-corporate taxpayers to understand:

• Excess Business Loss Limitation (IRC Section 461(l)): For tax years beginning after December 31, 2020 through December 31, 2028 (currently extended under law), non-corporate taxpayers, including sole proprietors, partners, and S corporation shareholders, may not deduct aggregate business losses that exceed a threshold. For 2025, that threshold is $313,000 for single filers and $626,000 for married filers filing jointly (these amounts are adjusted for inflation annually). Business losses in excess of these thresholds become an NOL to be carried forward rather than deducted in the current year. Note: These threshold amounts are subject to inflation adjustment, and the provision's current status and future applicability should be confirmed for each tax year.
• Passive Activity Loss Rules (IRC Section 469): Losses from passive activities generally cannot offset non-passive income. They are suspended and carried forward to future years when the taxpayer has passive income or disposes of the passive activity. Passive losses that remain suspended generally do not create or increase a current-year NOL.
• At-Risk Rules (IRC Section 465): A taxpayer may only deduct losses up to the amount they have at risk in the activity. Amounts borrowed from parties with an interest in the activity, or amounts otherwise protected against economic loss, are generally not at risk.
• Hobby Loss Rules (IRC Section 183): If the IRS determines that an activity, informally known as a "hobby," is not entered into for profit, losses from that activity are generally not deductible for tax years after 2017 under current law.

Current NOL Carryforward and Carryback Rules: What the Law Says Today

The Tax Cuts and Jobs Act (TCJA), enacted in December 2017 and effective for most provisions beginning in the 2018 tax year, significantly changed how NOLs work for most taxpayers:

For most businesses that generated losses in 2018 or later, the carryback option is generally not available. The indefinite carryforward is potentially more valuable for long-term planning, but the 80 percent limit means a tax year with a very large NOL carryforward may still produce taxable income: at least 20 percent of taxable income in the year of use will generally remain subject to tax. The exact calculations depend on the specific facts and the applicable rules for the tax year in question.

How Does This Apply to Nevada Business Owners?

Nevada does not impose a personal income tax or a corporate income tax. This means that Nevada business owners and individual taxpayers do not have a state income tax against which to apply an NOL at the state level. The NOL rules described in this article are federal rules only.

However, this does not mean Nevada business owners have no tax obligations beyond federal income tax. Depending on the nature and size of the business, other obligations may include:

• Nevada Modified Business Tax (a payroll-based tax applicable to employers above certain wage thresholds)
• Nevada Commerce Tax (applicable to businesses with Nevada gross revenue exceeding $4 million per year)
• Nevada sales and use tax obligations
• Federal payroll tax obligations (which are separate from federal income tax and are not affected by an NOL)
• Federal self-employment tax for sole proprietors and partners (also not directly reduced by an income-tax NOL)

In short, using an NOL carryforward on your federal return does not eliminate or reduce your Nevada business tax obligations or your federal payroll and self-employment tax liabilities. It affects federal income tax only.

A Detailed Numerical Example: How an NOL Carryforward May Work

The following example is simplified for illustration purposes. Real-world calculations depend on the taxpayer's specific facts and applicable rules. This is not a guarantee of any particular tax outcome.

Assumed Facts

Assume Maria is a sole proprietor who operates an online retail business, reporting income on Schedule C. In Year 1 (2024), her business had gross income of $40,000 and allowable deductible business expenses of $115,000, including startup costs, inventory write-downs, and equipment depreciation. Maria had no other income in Year 1. After completing the required NOL modifications on Form 1045 or in her tax records, her calculated NOL for Year 1 is $60,000.

Applying the NOL in Year 2

In Year 2 (2025), Maria's business recovers and generates $75,000 in net taxable income before considering the NOL carryforward. She applies her $60,000 NOL carryforward, subject to the 80 percent limitation:

• Year 2 taxable income before NOL: $75,000
• Maximum NOL deduction allowed (80% of $75,000): $60,000 (the full $60,000 NOL is within the 80% limit of $60,000)
• Taxable income after NOL deduction: $75,000 − $60,000 = $15,000
• Remaining NOL carryforward: $0 (the full $60,000 was used)

If Maria's marginal federal income tax rate in Year 2 is assumed to be 22 percent, the simplified federal income tax effect of the $60,000 NOL deduction in Year 2 could be approximately $13,200 in reduced federal income tax liability (before considering any other limitations, credits, or adjustments that may apply). A deduction is not a dollar-for-dollar tax savings; the actual tax benefit depends on the applicable marginal rate and the taxpayer's complete tax situation.

What Records Should You Keep to Support an NOL?

Proper documentation is not optional; it is what allows you to defend an NOL if the IRS asks questions. At a minimum, you should maintain:

• The original tax return (Form 1040, 1120, or 1120-S) for the year that generated the NOL, with all schedules attached
• A completed NOL calculation worksheet (Form 1045, Schedule A, or a comparable workpaper)
• All business records supporting the deductions that created the loss: receipts, invoices, bank and credit card statements, payroll records, depreciation schedules, lease agreements, and similar documentation
• Carryforward tracking: each subsequent year's return should reflect the remaining NOL balance after any deduction taken
• Any basis calculations for S corporation shareholders, partnership interests, or real estate activities where at-risk or passive activity rules apply

Keep these records for as long as the NOL carryforward remains on your books, plus the applicable statute of limitations period for each year the NOL is used (generally three years from the return due date or the date of filing, whichever is later, though longer periods may apply in certain circumstances).

Common Mistakes That Create Problems with NOLs

• Treating any negative taxable income as an NOL: The NOL calculation requires specific IRS modifications. Negative taxable income on a return does not automatically equal the NOL available to carry forward. The actual NOL amount must be calculated separately.
• Forgetting the 80 percent limitation: Many taxpayers assume they can use the full NOL carryforward to zero out taxable income. Under current law, the deduction is generally limited to 80 percent of taxable income in the carryforward year. Failing to apply this limit results in an incorrect return.
• Ignoring the excess business loss limitation: Non-corporate taxpayers with very large business losses may have their current-year deduction capped by IRC Section 461(l), with the excess automatically converting to an NOL carryforward. This must be calculated on Form 461 and reflected properly on the return.
• Assuming passive losses create an NOL: Suspended passive losses from rental activities or other passive investments do not create or increase an NOL. Only deductible losses, those not blocked by the passive activity, at-risk, or hobby loss rules, can generate an NOL.
• Failing to disclose the carryforward on subsequent returns: An NOL carryforward should be reflected on each year's return even if it is not fully used that year. Failing to track and disclose the carryforward can cause problems when you try to use it later.
• Disposing of records too early: Because the IRS can audit the year an NOL is used and look back to the year that created it, discarding records from the loss year before the carryforward is fully consumed is a serious risk.

What Should Business Owners Do Next?

If you experienced a loss year in your business, or if you anticipate one, here are practical steps to consider:

1. Determine whether you actually have an NOL. Do not assume. Work with a tax professional to complete the required NOL calculation with the proper IRS modifications. The calculation must be done correctly to protect the carryforward.
2. Track the NOL precisely. The carryforward balance must be updated each year as you use it. An error in the balance compounds over time.
3. Consider future income projections. An indefinite NOL carryforward is most valuable in years when you have substantial taxable income. Planning future income recognition, for example, timing the sale of an asset or deciding when to take a distribution, can affect how efficiently you absorb the NOL.
4. Do not overlook entity structure. If you operate as an S corporation, partnership, or LLC, the flow-through of losses has additional rules, such as basis limitations, at-risk rules, and passive activity rules, that must be analyzed at the owner level, not just the entity level.
5. Stay current on law changes. Several provisions affecting NOL rules, including the excess business loss limitation and potential TCJA modifications, are subject to legislative change. Consulting a qualified tax professional regularly, especially as major legislation is considered, is important. You can schedule a consultation here to discuss how current rules apply to your specific situation.