How to Leverage Operating Losses for Tax Savings and Financial Recovery

Table of Contents

• What Are Net Operating Losses?
• Key Tax Provisions for NOLs
• NOL Planning Strategies
• How We Can Help

Operating losses, often seen as setbacks, can be transformed into strategic tax-saving tools to bolster financial recovery. Businesses experiencing losses can use provisions in the Internal Revenue Code (IRC) to unlock refunds or reduce future tax liabilities. Here’s a guide to understanding and leveraging these tax strategies.

What Are Net Operating Losses?

Net Operating losses (NOLs), generally governed by Section 172 of the Internal Revenue Code (IRC), occur when a company’s allowable tax deductions exceed its taxable income for a given period. These losses can arise from various factors, such as high startup costs, unexpected economic downturns, or significant one-time expenses.

Key Tax Provisions for NOLs

1. Carryforward Provisions: Under the current tax rules, NOLs can be carried forward indefinitely to offset taxable income in future years. However, only NOLs generated prior to 2018 can be used to offset up to 100% of a corporation’s taxable income. Those generated post-2018 are limited to offsetting up to 80% of future taxable income.
2. Carryback Provisions: While the Tax Cuts and Jobs Act (TCJA) eliminated NOL carrybacks for most businesses starting in 2018, there are exceptions. For instance, certain farming businesses and insurance companies retain carryback privileges.
3. Section 382 Limitations: Section 382 imposes restrictions on the use of NOLs following a significant ownership change, which is generally defined as a greater than 50% change in the ownership of stock among certain 5% shareholders of a company over a three-year period. These limitations are designed to prevent new owners from taking undue advantage of a company’s pre-existing losses. The rules regarding Section 382 are complex, particularly when identifying 5% shareholders, as ownership from related parties or entities must often be aggregated. The amount of taxable income that can be offset by NOLs is capped annually, based on the fair market value of the company’s equity immediately before the ownership change, multiplied by the long-term tax-exempt rate.

Special rules apply under Section 382 when dealing with built-in gains or losses. If the company’s assets appreciate significantly post-change, those gains can impact the utilization of NOLs.

Conversely, if there are significant built-in losses, they may further limit NOL application. Businesses undergoing transactions should carefully evaluate how Section 382 applies to their situation, as these limitations can significantly reduce the tax benefits associated with NOLs.

4. Separate Return Limitation Year (SRLY) Rules and Limitations: SRLY rules govern the ability of a member of a consolidated group to utilize NOLs generated prior to joining the group. Under SRLY rules, pre-consolidation NOLs can only offset income generated by the same entity that originally incurred the losses. This ensures that one member’s losses do not unfairly benefit the entire group.

SRLY rules add another layer of complexity for businesses undergoing mergers or acquisitions.

Companies must carefully track the origin of NOLs and evaluate how these rules impact the consolidated group’s ability to leverage those losses.

5. Impact of the capitalization of Research & Experimental (R&E) expenses under section 174: For tax years beginning after December 31, 2021, the new treasury regulations impose that companies capitalize and amortize over 5 years (15 years for foreign expenses) their R&E expenses instead of deducting them in the year incurred. Due to this change, many technology companies with substantial NOLs are now facing taxable income for the first time, as they must capitalize rather than immediately deduct their research and experimental costs.
6. California NOL Rules: For tax years 2024–2026, California has reinstated a suspension of the net operating loss (NOL) deduction for corporate taxpayers with net business income exceeding $1 million. These restrictions highlight the importance of state-level NOL planning, as they can significantly impact taxpayers operating in California. 

NOL Planning Strategies

1. Plan for Taxable Income: Strategically timing income recognition and deductible expenses can help businesses maximize the utility of NOLs. For example, deferring deductions to high-income years can enhance the impact of carryforward deductions, while accelerating expenses during low-income years can increase the size of an NOL, making it more effective for offsetting future taxable income.
2. Leverage State-Level NOLs: While federal rules govern NOLs, states often have their own provisions, including different carryforward and carryback rules. Reviewing state-level guidelines ensures businesses do not overlook valuable tax-saving opportunities.
3. Acquisition Planning: Companies acquiring loss-making businesses can integrate NOL strategies into their due diligence process to maximize post-transaction tax efficiencies.

How We Can Help

Navigating the complexities of NOLs requires expertise and strategic foresight. Our team of experts can help you analyze your financial history to identify eligible operating losses, and assist with transaction structuring and other strategies to maximize NOL deductions for businesses at both the federal and state levels. 

NOLs don’t have to signal defeat—with the right strategies, they can become powerful tools for tax savings and financial recovery. Let us help you turn your losses into opportunities.