Making a financial loss doesn’t have to be the end of the world. Tax loss carryforwards and carrybacks can be a useful part of your tax strategy in this regard. After all, they can be used to offset personal or business losses against your future or past taxable income. That way, you can alleviate your tax liability now, by transferring it back or forward.
In this blog, we’ll walk you through everything you need to know about maximizing carryforwards and carrybacks, from when to use them and how, to the potential benefits.
Understanding Tax Loss Carryforwards and Carrybacks
Before we get into how they can be used to bolster your tax planning, let’s start by defining what these terms mean.
What is a tax loss carryforward?
A tax loss carryforward lets you apply a net operating loss (NOL) or capital loss to future tax years, in order to offset your future income. The former applies only to businesses, while the latter can be used by companies, or in your personal taxes.
So if you or your business incur a loss in a specific tax year, you can use it to reduce taxable income in the future, when you’re making more of a profit.
As part of the Tax Cuts and Jobs Act (TCJA), NOLs are to be carried forward indefinitely, as long as they don’t exceed a limit of 80% of your taxable income per year.
For instance, say your business had a $5 million NOL in 2023, and earned $6 million in 2024. You can use up to 80% of that loss (an amount of no more than $4.8 million) to reduce your 2024 taxable income. In other words, only the difference ($1.2 million) is taxable in 2024. The leftover $200,000 can then be carried forward to upcoming tax years until your business has fully utilized the loss.
And what about capital losses? Selling assets like bonds, real estate, stocks, or equipment, at a different price to what was paid for them results in capital gains and losses. As such, it’s possible to incur capital loss carryforwards both as an individual, and professionally. For personal taxes, these losses can offset your ordinary income up to a maximum of $3,000. If your loss is greater than this limit, it may be carried over to future tax years.
As for businesses, capital losses can be used to offset capital gains.
What is a tax loss carryback?
A carryback works in a similar way. It lets you apply a loss to previous tax years. That way, you might be able to get a refund for taxes you’ve already paid. Note that the TCJA eliminated the two-year carryback for most businesses. It is now only available in a limited capacity to companies in certain industries, like farming.
For example, say you’re the owner of a sole proprietorship and you earned $100,000 in taxable income in 2023, and paid $20,000 in taxes, at a rate of 20%. However, the next year, you report a $50,000 NOL. You can carry this back to your 2023 taxes, to have a revised taxable income of $50,000 for 2023. In this instance, it would halve your 2023 tax liability from $20,000 to $10,000. This means you’d be entitled to a $10,000 refund from the IRS!
The key difference
In a nutshell, the major difference between carryforwards and carrybacks is timing. Instead of waiting for a future profitable year to benefit from a carryforward, a carryback lets you get an immediate refund on past taxes.
However, both rely on the fact that you paid enough taxes in the past, or will do so in the future, to offset the loss.
Benefits of Tax Loss Carryforwards and Carrybacks
The major benefit of both carryforwards and carrybacks is that you can offset your losses against future profits, or past profits.
Both options mean a lower current tax liability. And this can provide a much-needed financial cushion for businesses with fluctuating profits.
But keep in mind that when it comes to state taxes, the laws about carryforwards and carrybacks may differ from federal rules. In fact, only California, Idaho, Mississippi, Montana, and New York currently have carryback provisions.
As such, it’s always best to consult with a tax pro to make sure you get the most benefits from your tax strategy.
How to get the most benefit
If you want to make use of either method of lowering your tax liability, it’s crucial to plan strategically, and base this decision on your current financial situation. For example, carrybacks can provide you with short-term benefits, but carryforwards might actually be more advantageous if your company expects higher future earnings.
But this means you need to accurately estimate your future profitability. It’s also important to carefully time the sale of any assets to make the most of capital losses.
Also keep in mind that the laws surrounding carrybacks and carryforwards might change in the future – after all, they have done so in the past. There’s no guarantee that either option will be available indefinitely. To ensure you don’t get caught out by any possible alterations to regulations, you’ll need to review tax laws that affect your business on a regular basis.
Planning for and Utilizing Tax Losses
As with any tax strategy, making use of tax loss carryforwards and carrybacks means you’ll need to maintain accurate records. This will help your finance team to ensure that any losses are calculated correctly, so that they can be applied where necessary. This is also a great way to preempt any potential queries from the IRS, including a possible audit.
If you claim carryforwards, you need to include your previous-year tax returns that demonstrate the loss. You must also complete and submit the correct schedules on your tax return. For example, if you’re reporting capital losses, complete Schedule D.
Without the right paperwork and supporting documents, you run the risk of carryforwards being delayed or being disqualified for them.
Remember also that you need to meet the eligibility requirements to make use of carrybacks. For instance, not all losses can trigger eligibility. Only certain events, such as economic hardships or natural disasters are generally considered.
Navigating Tax Regulations and Compliance
To properly claim tax loss carryforwards and carrybacks, you need to ensure that you follow the IRS’ strict guidelines. That means filling in the right paperwork. For carrybacks, that means Forms 1045 or 1139. You’ll also need the Capital Loss Carryover Worksheet for carryforwards.
Reporting either of these options incorrectly can cost you. You or your business could face penalties with interest charges. As such, ensure that you avoid making common mistakes like miscalculating eligible losses, or trying to use the same loss across multiple years.
To ensure accuracy and consistency in your paperwork, consider reaching out to a tax pro. Tax advisors can help you navigate the regulations for tax loss carryforwards and carrybacks. They can also incorporate these into your long-term planning. And they’ll be able to help you stay on top of tax laws. After all, the US tax code is over 2500 pages and changes regularly.
For help navigating carrybacks and carryforwards, or to develop a personal or business tax strategy, schedule a Discovery Call with one of our CPAs today!
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