What are Net Operating Losses?

Net operating losses occur when the operating expenses of a business exceed the income for multiple years. Operating expenses are the costs of materials, rent, and overhead incurred when running a business. Income is all money that flows into a business, usually from the sales of materials or services.

Business losses are incurred throughout the year, but the annual tax reporting process is often when net operating losses are identified. In order to encourage entrepreneurship and to accommodate the ups and downs of the economic cycle, most countries have special rules surrounding tax treatment of net operating losses. Although income gains are restricted to the year they are earned, losses can be applied to future and past income statements

Typically, a business net operating loss can be used to reduce taxable income in more profitable years. This results in a lower income tax percentage and lower payment overall. In order to support a claim to reduce business income taxes, any net operating losses must be supported by financial statements.

All taxation departments have the right to audit a claim up to seven years prior to the current tax year. In an income tax audit, a trained accountant requests access to supporting documentation that substantiates the claim of net operating losses to the business. This may include copies of invoices from suppliers and invoices to customers. Banking records and reconciliations can also be reviewed to ensure that all transactions are accurately recorded.

Net operating losses have a special carryforward and carryback provision. Under this rule, a business can apply the net operating loss to reduce the taxable income for between two and three prior years. This process is designed to accommodate the cyclical nature of the business and economic cycle. The net operating loss can also be extended forward for the next 20 years.

By providing the ability to move losses forwards and backward in time, the government is acknowledging that the expenses incurred for current revenue may have occurred in prior years. It is also a relatively painless way to provide short term funding to normally profitable businesses in a period of economic downturn. There are very specific rules and conditions that must be met in order to qualify for this type of tax reduction.

To learn if these types of losses can be used to reduce your income tax obligation, consult with an accountant or review the income tax laws for your country. Most counties published their income tax guidelines on the internet, making them freely available to anyone to review. The rules surrounding net operating losses are very simple and straightforward. If your situation is complicated by other factors, discuss this with your accounting services firm to determine the best course of action for your firm.