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Thursday, September 30, 2010

Tax Treatment of Net Operating Losses

Mark P. Keightley
Analyst in Public Finance

A net operating loss (NOL) is incurred when a business taxpayer has negative taxable income. An NOL can be used to obtain a refund for taxes paid in the past and/or to reduce future tax obligations. The process of using an NOL to refund previously paid taxes is known as an NOL carryback, whereas the process of using an NOL to reduce future taxes is known as a carryforward. Under current law, there is a 2-year carryback period and a 20-year carryforward period for most business taxpayers. The intent of the NOL carryback/carryforward provision is to give taxpayers the ability to smooth out changes in business income, and therefore taxes, over the business cycle.

The 2-year carryback period was temporarily extended for up to up to 5 years during 2008 and 2009 to provide assistance to businesses hurt by the economic downturn. Extending the carryback period likely enhanced the ability of firms to smooth income by allowing losses to be offset against a longer period of past profits rather than having them carried forward. The extension, however, decreased revenue accruing to the federal government.

Economic theory suggests that, under certain conditions, extending the carryback period indefinitely could minimize the distorting effects taxation has on investment decisions and, in turn, increase economic efficiency. This result stems from the observation that the majority of the tax burden falls on risky investments. The government, by allowing NOL carrybacks, effectively enters into a partnership with taxpayers when losses are allowed to be carried back, sharing both the return to investment (tax revenue) and the risk of investment (revenue loss). Extending the carryback period indefinitely would reduce the tax burden by reducing the private risk associated with investing. Further gains in economic efficiency are possible if the government can spread risk better than can be done in private markets. Those gains, however, come at the expense of lost federal revenue.

This report explains the current law and recent modifications made during the economic downturn. In addition, this report highlights a number of policy considerations relating to the extension of the NOL carryback period.

Date of Report: September 8, 2010
Number of Pages: 12
Order Number: RL34535
Price: $29.95

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