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Net operating losses occur when a company’s operating expenses exceed revenue for several years. Operating expenses are the costs of materials, rent, and overhead incurred while running a business. Revenue is all the money that comes into a business, usually from the sale of materials or services.
Business losses occur throughout the year, but the annual tax filing process typically takes place when net operating losses are identified. In order to encourage entrepreneurship and adapt to the ups and downs of the business cycle, most countries have special rules regarding the tax treatment of net operating losses. While income gains are restricted to the year earned, losses can be applied to past and future income claims.
Typically, a business net operating loss can be used to reduce taxable income in more profitable years. This results in a lower income tax percentage and a lower overall payment. To support a business income tax reduction claim, any net operating loss must be supported by financial statements.
All tax departments have the right to audit a claim up to seven years prior to the current tax year. In an income tax audit, a trained accountant requests access to supporting documentation that proves the net operating loss claim for the business. This may include copies of vendor bills and customer bills. Bank records and reconciliations can also be reviewed to ensure all transactions are recorded accurately.
Net operating losses have a special provision for carryover and compensation. Under this rule, a company can apply the net operating loss to reduce taxable income for the previous two or three years. This process is designed to accommodate the cyclical nature of the business and economic cycle. The net operating loss can also be extended to the next 20 years.
By providing the ability to move losses back and forth in time, the government is recognizing that expenses incurred for current revenue may have occurred in prior years. It is also a relatively easy way to provide short-term financing for normally profitable businesses in times of economic downturn. There are very specific rules and conditions that must be met in order to qualify for this type of tax relief.
To find out if these types of losses can be used to reduce your income tax liability, consult an accountant or check the income tax laws of your country. Most counties have posted their income tax guidelines online, making them freely available for review. The rules around net operating losses are very simple and straightforward. If your situation is complicated by other factors, discuss it with your accounting services firm to determine the best course of action for your business.