Net Operating Loss Carryforward

When, where and how to do it

(wHdc) The Net Operating Loss, as applied to individuals and small businesses, is one of the most complicated features of the U.S. Tax Code, perhaps second only to the calculation of recaptured depreciation. The IRS does not explain it clearly. In fact, I have found no resource which explains it clearly, that is why I created this article. This is Page One, of a multi-page article which will investigate the Net Operating Loss calculation.

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Written 2009 by Will Johnson
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Some online resources related to this topic

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What is it? Does it apply to me?

The Net Operating Loss, in the U.S. Tax Code, as applied to individuals and small businesses, and it's provisions for carry back and carry forward are exceedingly complex.  Turbotax does not adequately address this feature, in fact they don't even include Form 1045.  The best they accomplish toward it, is confusing and contradictory instructions and the unhelpful entry box "Net operating loss available to carry forward".  The only explanations given in the program, for how to calculate this, are inadequate.  Most parts of Turbotax are very good, but on this part, they fall face down.  Why? Because, nobody can understand Form 1045.

Note: This article only addresses these issues for individuals and small businesses, and neither for corporations, nor for trusts.

IRS Publication 536 addresses certain aspects of the Net Operating Loss.  The very important first step being the question, "Do I have a Net Operating Loss that I can carry forward or carry back?"  The simplest answer is to look at your prior year's Income Tax Return.  For individuals who filed using Form 1040NR, look at line 38, for individuals who filed using Form 1040, look at line 41.  If the amount shown there, on your return, is not negative, then you do not have a Net Operating Loss.  Stop.  Leave.  You're done.

If it is negative, then you may have a Net Operating Loss.  The reason that I here say "may" and not "do", is because that line of your tax return includes items which are not allowed when calculating your Net Operating Loss.  So let's take a moment to ponder this question, "What does it mean to have a loss, have it be net, and have it be operating?"

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You have a Net Operating Loss, if you have businesses which for that year, spend more money than they take in.  That is, your expenses exceed your income for your businesses for that year.  By "operating" the I.R.S. essentially means an "active" as opposed to a "passive" loss.  This distinction is related to Schedule C versus your other schedules.  In order to have an active loss versus a passive loss, you must have filed a Schedule C.  Losses on Schedule D, and losses on Schedule E cannot be carried back.  They are called suspended losses, and must be carried forward.  They are not part of any "Net Operating Loss" because they are passive losses.

You cannot calculate your Net Operating Loss by simply looking at your Schedule C.  This is because there are items which go into the Net Operating Loss calculation which do not appear on Schedule C, but rather in other places in your return.  There is no place in fact, anywhere in your return, where you can simply "get the answer", this is because the opposite is also true.  Some figures in your return include amounts which are not allowed as part of your Net Operating Loss calculation.  So the calculation itself requires a new special worksheet, or a bunch of figuring it out on a piece of scratch paper.

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A special note for Stock Market investors (and other Schedule D losses)

Losses on Schedule D, which exceed your limitation, or where you otherwise have a negative net income for that year, must be carried forward.  They are called suspended losses.  You carry them forward, applying them to future Schedule D gains until used up.

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Continue on to Page Two: Calculating your Net Operating Loss (beware, here be dragons)

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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Comments

"active vs. passive?"


Thanks for putting up this site & info. I have a question about the following excerpted sentence:

"In order to have an active loss versus a passive loss, you must have filed a Schedule C. Losses on Schedule D, and losses on Schedule E cannot be carried back."

--I have an active loss on my Schedule E (K-1 1120) from my Sub-S, in which I "actively" participate, hence I should be able to carryback, correct? Am I misunderstanding your use of the terms "active vs. passive?" Thank you! -Joe

Anonymous - 16 Apr 2011

It's my understanding that losses on Schedule E can only be carried forward as suspended losses, but I may be wrong. I have not studied that situation at all.

Will Johnson - 16 Apr 2011