A net operating loss occurs when a taxpayer’s business deduction exceed business income. Taxpayers are allowed to carry net operating losses back to the two prior tax years. If net operating losses still remain after the carryback, they may be carried forward for 20 years. Thus, a net operating loss incurred in 2008 can be carried back to 2006 and 2007 and carried forward to 2028.
How a Net Operating Loss Generates Cash
As small businesses persevere through a dismal economy, cash flow is one of the most pressing concerns. Businesses lacking funds to pay employees or purchase supplies may fail if they cannot borrow to meet current obligations. With the credit markets virtually frozen, short-term borrowing is not an option for some small businesses. Many of these businesses are likely to incur a net operating loss for 2008, even if they were profitable in prior years. Ironically, a net operating loss (which is bad) can be used to generate current cash (which is good).
The procedure of turning net operating losses into cash is the net operating loss carryback. A carryback is more complicated than a carryover because it involves prior years’ tax returns. If a 2008 net operating loss is carried back to 2006, the deduction will decrease the amount of tax due for 2006, and the excess taxes are refunded. The refund puts immediate cash in the hands of the struggling business owner. Unlike a loan, a tax refund does not have to be repaid because it represents an overpayment of tax rather than a liability. In contrast to a carryback, a carryover saves taxes in future years, which does not provide the relief needed immediately..
Net Operating Loss Carrybacks as Relief Measures
Unlike the financial and automaking sectors, small businesses will not receive federal bailout funds and the government will not loan them money or purchase their equity. One relief measure that could benefit small businesses is to increase the cash that can be generated with a net operating loss carryback. For example, if a 2008 net operating loss could be carried back for four years rather than two years, the taxpayer would have an additional two years’ taxable income to absorb the loss and produce a refund.
Congress recently used the carryback period in order to alleviate the uncertain economic conditions following the terrorist attacks on September 11, 2001. For net operating losses incurred in taxable years ending in 2001 or 2002, the carryback period was extended from two years to five years. The carryover period was unchanged. H.R. Rep. No. 107-251 explained that the events of September 11 caused many taxpayers to experience unexpected operating losses. According to the Report, the refunds could be used to increase cash flow or make capital investments and other payments that would stimulate the economy.
Extending the net operating loss carryback period continues to be discussed as a potential relief or stimulus for small businesses. Leading up to the enactment of the Foreclosure Prevention Act of 2008, signed by President Bush on July 30, 2008, the Senate bill (S. 2636) called for extending the carryback period from two years to four years for net operating losses incurred during 2008 and 2009. The net operating loss provision was not included in either the House bill (H.R. 3221) or the final legislation.
Senator Olympia J. Snowe (R- ME) on Jan 24, 2008, proposed an additional stimulus package that would contain tax relief provisions for small businesses. One of the provisions she suggested was to extend the carryback period for net operating losses to five years for net operating losses sustained in 2008 and 2009. Similarly, Senator Orrin G. Hatch (R-Utah), a December 16, 2008, letter to the leaders of the Senate Finance Committee, proposed a permanent extension of the carryback period to ten up to 15 years. In the letter, Senator Hatch warned that the refunds from a longer carryback period could make the difference between “staying in business and shutting the doors forever.”
As Congress continues to provide billions to rescue the titans of the financial and auto industries, it will probably come under increasing pressure to provide some direct relief for small businesses. Given the precedent of allowing a longer carryback period after September 11 and the current references to an extension, it is possible that in 2009 Congress will enact a provision, probably temporary, to extend the carryback period for net operating losses beyond the present two years.