A net operating loss (NOL) can reduce a business’s future federal income taxes: under current law, NOLs arising in tax years beginning after 2017 can generally be carried forward indefinitely and used to offset up to 80% of taxable income in a later year, but generally cannot be carried back. The value of those losses can be sharply limited after an ownership change under Section 382, and California has temporarily suspended NOL deductions for larger taxpayers for 2024 through 2026. Planning ahead, especially before a financing or acquisition, helps preserve the benefit.
Losses are common in a company’s early years, whether from startup costs, heavy research spending or a downturn. Here is how NOLs work and how to keep them useful.
What Is a Net Operating Loss?
Under Section 172 of the Internal Revenue Code, a net operating loss generally arises when a taxpayer’s allowable business deductions exceed its gross income for the year, after certain adjustments. A C corporation keeps its NOLs at the corporate level. For S corporations, partnerships and most LLCs, losses pass through to the owners, who can use them only to the extent of their basis and subject to the at-risk, passive activity and excess business loss limits. If you own an S corporation, see understanding S corporations.
Federal Carryforward and Carryback Rules
- Losses from tax years beginning after 2017 can generally be carried forward indefinitely, but in a given year they can offset only up to 80% of taxable income (computed before the NOL deduction).
- Losses from tax years beginning before 2018 follow the older rules: they can offset 100% of taxable income but generally expire after a 20-year carryforward period.
- Carrybacks were generally eliminated for losses arising after 2017, with limited exceptions such as certain farming losses and some insurance company losses. The CARES Act temporarily allowed five-year carrybacks for losses arising in 2018 through 2020, so older amended returns may reflect those rules.
Section 382: Ownership Changes
Section 382 limits the use of NOLs after an “ownership change,” generally defined as an increase of more than 50 percentage points in the ownership of the company’s stock by one or more 5% shareholders over a rolling three-year testing period. Ownership changes can happen in acquisitions, but they can also result from a series of venture financings, option exercises and secondary sales over time, so startups can trigger one without realizing it.
After an ownership change, the amount of pre-change NOLs the company can use each year is generally capped at the value of the company’s stock immediately before the change multiplied by the long-term tax-exempt rate published by the IRS. Other key points:
- If the company does not continue its business enterprise for two years after the change, the limitation can be reduced to zero.
- Built-in gains and losses in the company’s assets at the time of the change can increase or further restrict the limitation.
- Identifying 5% shareholders can require aggregating holdings of related persons and treating smaller public holders as groups, which makes the analysis technical.
- A related provision, Section 383, applies similar limits to credits, such as research credits.
Before a large financing or sale, it is often worth running a Section 382 study so the parties understand how much of the NOL will remain usable.
Consolidated Returns and SRLY Rules
When a corporation joins a consolidated group, its pre-acquisition losses are generally subject to the separate return limitation year (SRLY) rules. These rules typically allow those losses to offset only income attributable to the member that generated them, and they can overlap with Section 382. Acquirers should track the origin of each loss and model how SRLY and Section 382 together affect its value. See our mergers and acquisitions page.
Research Expenses and Section 174
For tax years beginning after 2021, the Tax Cuts and Jobs Act required businesses to capitalize research and experimental expenditures and amortize them over five years (15 years for research performed outside the U.S.). That change caused many technology companies with losses on their books to show taxable income. Legislation enacted in 2025 restored immediate deduction of domestic research expenses for tax years beginning after 2024 and created transition rules for previously capitalized domestic costs, including an option for certain small businesses to apply the change retroactively. Foreign research costs remain subject to 15-year amortization. Because these rules affect both NOL size and timing, companies should review elections with their tax advisors.
Separately, qualified small businesses may be able to apply part of the federal research credit against payroll taxes, which can be useful for a company with losses and no income tax liability.
California NOL Rules
California generally follows the federal NOL concept but has its own rules. For tax years 2024, 2025 and 2026, California suspended NOL deductions for taxpayers with net business income or modified adjusted gross income of $1 million or more, extended the carryover period for suspended losses, and also limited the use of certain business credits. Smaller taxpayers below the threshold are not subject to the suspension. Companies with California operations should factor this into cash tax projections for those years.
NOL Planning Strategies
- Track ownership changes. Keep a cap table history that makes Section 382 testing possible, and consider the effect of each financing.
- Model the 80% limit. Even with large NOLs, a profitable year may still produce federal tax because only 80% of taxable income can be offset by post-2017 losses.
- Review timing elections. Accounting method changes, depreciation elections and research expense elections can change when income and deductions are recognized and how quickly losses are used.
- Consider state rules separately. State carryforward periods, apportionment and suspensions often differ from federal law.
- Value NOLs realistically in deals. Buyers rarely pay full face value for a target’s NOLs because of Section 382 and SRLY limits, and sellers should expect diligence on them.
- Document losses. The IRS can examine the year a loss arose when it is used years later, so keep supporting records.
The Takeaway
NOLs can be valuable, but their value depends on ownership history, the 80% limit, state rules and the company’s future income. Treat them as an asset that needs monitoring, especially around financings and acquisitions, and work with a qualified tax advisor on the calculations.
Frequently Asked Questions
How long can a business carry forward a net operating loss?
Federal NOLs arising in tax years beginning after 2017 can generally be carried forward indefinitely, subject to the 80% of taxable income limit. Losses from earlier years generally have a 20-year carryforward period.
Can a startup lose its NOLs after a funding round?
It can lose some of their value. If a series of financings and stock transfers produces an ownership change under Section 382, the company’s annual use of pre-change NOLs is capped, which can make much of the loss unusable in practice.
Does California allow NOL deductions right now?
California suspended NOL deductions for tax years 2024 through 2026 for taxpayers with net business income or modified adjusted gross income of $1 million or more. Taxpayers below that threshold can still use NOLs, and suspended losses get an extended carryover period.
Can NOLs be carried back to get a refund?
Generally not for losses arising after 2017, except in limited cases such as certain farming losses. Temporary carryback rules under the CARES Act applied to losses from 2018 through 2020.
How Sutter Law Can Help
Sutter Law advises companies on the legal side of financings and acquisitions that affect NOLs, including deal structure, tax representations and covenants, and works with clients’ tax advisors on Section 382 and related questions. Contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
