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. Don’t worry. We’re here to help. We’ll give you four strategies you can use to get an immediate tax benefit from your business loss. And the good news is that you’ll likely end up better off with our strategies than with your options before tax reform.
Old NOL Rules
You have an NOL when your business deductions exceed your business income in a taxable year. 1 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
- 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.
Don’t worry: we’ll show you how you can take proactive measures to use your business loss in the current tax year and avoid the limits that the new NOL rules put on your ability to use it.
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 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 tax-free 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.
Example. In 2018, John, who is single, takes the standard deduction and has a Schedule C loss of $30,000. John has no other tax items on his tax return. John has $55,000 in traditional IRA assets. John can convert $42,000 ($30,000 loss plus $12,000 of standard deduction) of his traditional IRA to a Roth IRA in 2018 and pay no tax on the conversion amount.
Strategy No. 2: 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. When you examine your appreciated assets for sale with this strategy, you likely will see assets that will generate:
- short-term capital gain,
- long-term capital gain,
- or ordinary income.
Because of the dollar-for-dollar offset of income, you want to sell assets that generate short-term capital gain and ordinary income. You have lower tax rates on your long-term capital gains, so save them for later, except when your business-loss (NOL) strategy creates a zero tax on your long-term capital gains.
Strategy No. 3: 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 the loss. 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).
Strategy No. 4: Fix Depreciation Errors Not in Your Favor
You can use the automatic accounting method change procedures to fix multi-year 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.
Tax reform took away your ability to get immediate tax benefits from your NOL: You can’t carry back your NOL to get tax refunds (except for qualified farming losses). Your NOL carryforward can only offset up to 80 percent of your taxable income in a tax year. This article gives you four strategies to make your business loss work for you immediately by using it to offset income from converting your traditional IRA into a Roth IRA, purging gains from appreciated property, delaying payment of expenses and accelerating income, and fixing depreciation errors that aren’t in your favor. 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.