What Is a Net Operating Loss and How Does It Reduce Your Taxes?

A net operating loss (NOL) occurs when your allowable tax deductions exceed your total gross income in a given tax year. The IRS allows you to apply that loss to other tax years, reducing taxable income and lowering your overall tax bill.

NOLs most commonly affect small business owners, freelancers, and self-employed individuals who spend more than they earn in a given year. For anyone running a business at a loss, understanding the NOL rules can turn a difficult year into meaningful future tax savings.

With that said, we explain how NOLs are calculated, who qualifies, how the carryforward and carryback rules work, and how to report an NOL on your federal tax return.

What Is a Net Operating Loss (NOL)?

A net operating loss is when a business or individual’s deductible expenses exceed the income for the tax year. It is not simply spending more than you earn since the IRS defines an NOL based on specific rules around which deductions qualify.

Common net operation loss causes include:

• Startup costs that exceed early revenue
• Disaster-related losses affecting a business
• Large depreciation deductions on business property
• Significant drop in sales with fixed overhead still running high

Only business-related losses and certain casualty or theft losses count toward a qualifying NOL. As for personal tax deductions, such as the standard deduction, personal exemptions, or capital losses beyond capital gains, these are generally excluded from the NOL calculation.

How to Calculate Net Operating Loss

Calculating a net operating loss requires subtracting your allowable business deductions from your gross income for the year. If the result is negative, you may have an NOL. That said, here’s how to calculate your net operating loss step by step:

• Start with your taxable income (or loss) from your tax return
• Add back the standard deduction or non-business itemized deductions
• Add back personal exemptions (if applicable to your tax year)
• Remove non-business capital losses that exceed non-business capital gains
• Add back any qualified business income deduction claimed on your return
• The resulting figure — if negative — is your NOL

If you’re self-employed, Schedule C income and expenses feed directly into this calculation. Tracking deductible expenses year-round through a self-employment ledger simplifies this process considerably and reduces the risk of errors at filing time.

NOL Example Calculation

To better understand how a net operating loss (NOL) works, let’s walk through a simple example. For instance, a freelance graphic designer reports the following on their tax return:

• Taxable income (loss): –$30,000
• Standard deduction: $13,850
• Non-business capital losses: $3,000
• Non-business capital gains: $1,000
• Qualified Business Income (QBI) deduction: $2,000

Begin with the reported taxable income and add back the standard deduction (–$30,000 + $13,850 = –$16,150). Then, remove excess non-business capital losses:

Excess loss = $3,000 – $1,000 = $2,000

–$16,150 + $2,000 = –$14,150

Lastly, add back QBI deduction: –$14,150 + $2,000 = –$12,150

Since the final number is negative, the taxpayer has a net operating loss of $12,150. However, this NOL can typically be carried forward to offset taxable income in future years, reducing overall tax liability.

Who Can Claim a Net Operating Loss?

Individual taxpayers, sole proprietors, single-member LLCs, C corporations, S corporations, and estates or trusts can all claim a net operating loss. How the NOL flows through depends on your entity type:

• For individuals and sole proprietors, the NOL flows directly to your income tax return.
• C corporations file separately and apply the NOL against corporate income.
• Partnerships and S corporations pass the loss through to individual partners or shareholders.

The fact of whether you are self-employed or a small business owner affects which entity rules apply to you, and how much of a loss can be carried forward.

What Are the NOL Carryforward and Carryback Rules?

NOL carryforward and carryback rules determine which tax years you can apply the loss to. The Tax Cuts and Jobs Act (TCJA) of 2017 overhauled these rules, and the current limitations are significantly different from what applied before 2018.

Under current IRS rules (for NOLs arising after December 31, 2017):

• No carryback: post-2017 NOLs generally cannot be applied to prior tax years
• Indefinite carryforward: the NOL can be carried forward until fully used, with no expiration
• 80% cap: the NOL deduction cannot exceed 80% of taxable income in the year it is applied

The 80% limit means you cannot eliminate your entire tax liability with an NOL alone in a carryforward year, as you will still owe tax on at least 20% of taxable income. The remaining unused NOL rolls into future years.

Also, it’s important to mention the CARES Act exception for 2018–2020 NOLs. The CARES Act temporarily reinstated the carryback provision for NOLs from tax years 2018, 2019, and 2020, allowing a five-year carryback.

If you had a loss in those years and did not use the carryback, you may still be able to amend your business tax return to claim a refund from prior profitable years.

NOL Rules: Pre-TCJA vs. Post-TCJA Comparison

With the abovementioned in mind, here’s a quick comparison regarding pre-TCJA vs. post-TCJA net operating loss rules:

How Do You Report a Net Operating Loss to the IRS?

Reporting an NOL depends on whether you are an individual or a corporation, and whether you are applying the loss in the current year or carrying it forward from a prior year.

• Individuals. Calculate your NOL using IRS Form 1045 (Application for Tentative Refund), or file an amended return on Form 1040-X. You can also attach a supporting statement to your current-year return showing the NOL amount and carryforward schedule.

• Corporations. Use Form 1139 (Corporation Application for Tentative Refund) for a fast refund, or Form 1120-X for an amended corporate return.

When carrying an NOL forward, track the full original amount, how much you apply each year, and the remaining balance on Schedule A of Form 1045. Keep those records accessible because if your return is flagged for a tax audit, the IRS may request your full carryforward documentation.

Also, the NOL deduction reduces your adjusted gross income (AGI), which can move you into a lower tax bracket, compounding the savings beyond the deduction itself.

How Does a Net Operating Loss Affect Your Tax Liability?

A net operating loss reduces taxable income in the year it is applied, which directly lowers the amount of income tax owed. Because the U.S. uses a progressive tax system, dropping your taxable income can shift you into a lower bracket entirely, multiplying the benefit.

For example, if your business generated a $60,000 NOL this year and you carry it forward to a year when you earn $120,000, the 80% cap limits your deduction to $48,000. Your taxable income drops to $72,000, which, depending on your filing status, could save tens of thousands of dollars in federal taxes.

However, NOLs do not reduce self-employment tax in the same way since it’s calculated on net earnings from self-employment, not on taxable income after the NOL deduction. Freelancers and sole proprietors should factor this into their quarterly tax planning so they are not caught short during the year.

How Does a Net Operating Loss Interact with Other Tax Benefits?

A net operating loss works alongside, but separately from other tax deductions and credits.

The qualified business income (QBI) deduction applies before the NOL in most cases. A business tax credit reduces the actual taxes owed dollar for dollar, while the NOL only reduces the income on which taxes are calculated.

The interaction between these tools makes proactive tax planning essential. Using an NOL in a high-income year yields greater savings than applying it in a year when you are already in a low bracket. Timing matters.

5 Common Mistakes to Avoid When Claiming an NOL

Getting the NOL calculation wrong can result in missed savings or IRS scrutiny. These are the five most frequent errors:

1. Including non-business deductions. Personal deductions like the standard deduction do not count in the NOL calculation.
   
   
2. Failing to track carryforward balances. Each year you apply an NOL, you must document what remains for future years.
   
   
3. Exceeding the 80% cap. Post-2017 NOLs cannot offset more than 80% of taxable income in the carryforward year.
   
   
4. Missing the CARES Act window. If you had losses in 2018–2020 and did not use the five-year carryback, check whether you still qualify.
   
   
5. Ignoring state-level rules. State NOL rules often differ from federal rules. Some states do not allow NOL deductions, while others use different carryforward periods.

Solid tax planning before filing ensures you apply the deduction correctly and in the most tax-efficient year. If your situation involves multiple carryforward years or multiple entity types, a licensed CPA can help you maximize the benefit legally.

Final Thoughts

A net operating loss can convert a difficult year into a long-term tax advantage, but only if you calculate it correctly and apply it within IRS rules. Understanding the 80% carryforward cap, the indefinite carryforward period, and the exceptions for farming and CARES Act years positions you to make the most of this deduction.

If your business is generating consistent losses, the earlier you document and track these figures, the easier it becomes to apply them accurately in future years. Paystub.org’s tools and resources for self-employed workers and small business owners can help you stay organized from day one, so nothing falls through the cracks when tax season arrives.

Net Operating Loss FAQs

#1. Can an individual (not a business owner) claim a net operating loss?

Yes, individuals can claim a net operating loss if their business-related or casualty deductions exceed income from all sources. The IRS permits this for sole proprietors, self-employed workers, and individuals with qualifying theft or disaster losses. Use IRS Form 1045 or attach a supporting statement to your return to document and apply the NOL.

#2. How long can you carry forward a net operating loss?

Under current tax law, a post-2017 net operating loss can be carried forward indefinitely. However, each year the deduction is capped at 80% of your taxable income. You continue rolling the remaining balance forward until it is fully used.

#3. Does a net operating loss reduce self-employment taxes?

No, a net operating loss does not reduce self-employment tax. Self-employment tax is calculated on net earnings from self-employment, which is determined separately from the income tax NOL deduction. Even if an NOL eliminates your income tax in a given year, you may still owe self-employment tax on your business earnings.

#4. What records do I need to support a net operating loss claim?

You need complete documentation of all income and business expenses for the year the loss occurred, a completed NOL calculation worksheet (Form 1045, Schedule A), and a year-by-year carryforward schedule showing the beginning balance, the amount used each year, and the remaining balance. The IRS recommends keeping these records for at least three years after the final year in which the NOL is used.