Since income taxes can be the largest single expense on the income statement, always carefully track the use and applicability of net operating loss (NOL) carryforwards that were created as the result of reported losses in prior years. An NOL may be carried back and applied against profits recorded in the two preceding years, with any remaining amount being carried forward for the next twenty years, when it can be offset against any reported income. If there is still an NOL left after the twenty years have expired, then the remaining amount can no longer be used. One can also irrevocably choose to ignore the carry back option and only use it for carry forward purposes. The standard procedure is to apply all of the NOL against the income reported in the earliest year, with the remainder carrying forward to each subsequent year in succession until the remaining NOL has been exhausted. If an NOL has been incurred in each of multiple years, then they should be applied against reported income (in either prior or later years) in order of the first NOL incurred. This rule is used because of the twenty-year limitation on an NOL, so that an NOL incurred in an earlier year can be used before it expires.
The NOL is a valuable asset, since it can be used for many years to offset future earnings. A company buying another entity that has an NOL will certainly place a high value on the NOL, and may even buy the entity strictly in order to use its NOL. To curtail this type of behavior, the IRS has created the Section 382 limitation, under which there is a limitation on its used if there is at least a 50% change in the ownership of an entity that has an unused NOL. The limitation is derived through a complex formula that essentially multiplies the acquired corporation’s stock times the long-term tax exempt bond rate. To avoid this problem, a company with an unused NOL that is seeking to expand its equity should consider issuing straight preferred stock (no voting rights, no conversion privileges, and no participation in future earnings) in order to avoid any chance that the extra equity will be construed as a change in ownership.
If a company has incurred an NOL in a short tax year, it must deduct the NOL over a period of six years, starting with the first tax year after the short tax year. This limitation does not apply if the NOL is for $10,000 or less, or if the NOL is the result of a short tax year that is at least nine months long, and is less than the NOL for a full twelve-month tax year beginning with the first day of the short tax year. This special NOL rule was designed to keep companies from deliberately changing their tax years in order to create an NOL within a short tax year. This situation is quite possible in a seasonal business where there are losses in all but a few months. Under such a scenario, a company would otherwise be able to declare an NOL during its short tax year, carry back the NOL to apply it against the previous two years of operations, and receive a rebate from the IRS.