Tax reform made a lot of good changes in the tax law for the small-business owner. But the changes to the net operating loss (NOL) deduction rules are not in the good-changes category. They are designed to hurt you and put money in the IRS’s pocket. Now, if you have a bad year in your business, the new NOL rules are designed to stop you from using your business loss to find some immediate cash. The new (let’s call them bad-for-you) rules certainly differ from the prior beneficial rules.
Old NOL Rules
You have an NOL when your business deductions exceed your business income in a taxable year. Before tax reform, you could carry back the NOL to prior tax years and get refunds of taxes paid in those prior years. Alternatively, you could have elected to waive the NOL carryback and instead carry forward the NOL to offset some or all of your taxable income in future tax years.
New NOL Rules
Tax reform made two key changes to the NOL rules:
- You can no longer carry back the NOL (except for certain qualified farming losses).
- Your NOL carryforward can offset only up to 80 percent of your taxable income in a tax year.
The changes put more money in the IRS’s pocket by
- eliminating your ability to get an immediate tax benefit from your NOL carryback, and
- delaying your ability to get tax benefits from future NOL carryforwards.
(See 26 U.S. Code § 172 – Net operating loss deduction here)
NOL Strategy No. 1: Roth IRA Conversion
If you have traditional IRA assets, you can convert them to Roth IRA assets regardless of income. You include the conversion amounts in your taxable income, but you don’t pay the 10 percent penalty on the converted monies.
This brings up a planning opportunity for your business loss. Use the loss to offset the income that you had to include because of the conversion to a Roth IRA. If your loss can offset the entire income inclusion, the conversion is tax-free to you, and the tax-free converted funds continue their growth taxfree inside the Roth IRA. You’ll also reduce future required minimum distributions (RMDs) after age 70 1/2 since you don’t take RMDs from a Roth IRA account.
NOL Strategy No. 2: Traditional IRA Purge
If you have a traditional IRA, instead of converting it to a Roth IRA, you can withdraw the IRA monies and use your business loss to make the distribution tax-free to you. If you can use your business loss to take the IRA funds out 100 percent tax free, it’s a win-win for you. What, a double win? Yes. Remember that you got a tax deduction when you put the money into the traditional IRA and paid zero taxes on the earnings that were growing inside the IRA. And now, using your business loss, you pay no taxes to the government on the way out.
The business loss eliminates the income taxes but doesn’t relieve you of the 10 percent penalty if you’re under age 59 1/2. But you may be able to use one or more of the many exceptions to the 10 percent penalty to make this a truly tax- and penalty-free distribution.
NOL Strategy No. 3: Purge Gains from Property
This is easy: you sell appreciated assets and recognize the gain. You use the business loss to offset the taxable gains. Since you sell the assets for a gain, you can immediately repurchase the
same assets if you want—there is no gain equivalent of the “wash sale loss” rule. Once you rebuy the assets, you lock in a new cost basis at their current fair market value.
NOL Strategy No. 4: Accelerate Income
If you are like most small businesses, you are on the cash method of accounting for tax purposes. Under the cash method, you recognize taxable income when you receive the cash and you recognize most expenses when you pay the money. Now you have a business loss to consider, and say you want income now to offset this loss. The strategy is to collect the taxable cash now and pay the deductible expenses next year.
- To speed up the collection of taxable income:
- increase your efforts to collect aged receivables,
- offer discounts to collect aged and perhaps all receivables,
- offer discounts for clients to prepay next year’s services,
- accelerate your invoicing schedule, and
- consider factoring receivables (selling them).
NOL Strategy No. 5: Fix Depreciation Errors Not in Your Favor
You can use the automatic accounting method change procedures to fix multiyear depreciation errors in a single year. If the errors you made were not in your favor (i.e., you overstated
depreciation in prior years), then the depreciation error-correction process creates a one-time spike in your taxable income. Rather than pay taxes out of pocket on this one-time income event, use your business loss to offset the income and fix the issue tax-free.
Final Thoughts
If you think you might have a business loss in 2018 or a future tax year, don’t sit by and do nothing: be proactive, plan, and bypass the restrictive NOL rules so that you can realize the benefits of that business loss immediately.
We are bringing the NOL rules to your attention in case you need to do some planning with us. We likely have some strategies that can help you get some immediate benefits from your business loss. If this is of interest, please call us at 509-543-7600.