The U.S. tax code has long included rules that allow a business to claim its excess losses (losses that exceed its current income) in a current year and then deduct those excess losses on tax returns of past and future years. However, you do not have to be a billionaire (or even a millionaire) to use the NOL rule -- it can work for ordinary taxpayers and small-business owners, too. Here is how:
If you have a business for which your deductions are more than your income for a particular year, you may be able to claim a NOL. If the business loss is more than you can claim for a particular year (because the loss reduced your income to zero), you are generally required to carry back the entire amount of the NOL to the two prior tax years and file amended returns with these new deductions.
If all of the NOL cannot be used against income in the two carry-back years, the remaining NOL is carried forward until it is depleted, for up to the next 20 years.
This is not a secret loophole for the rich, and, it is perfectly legal. The rules for deducting NOL’s are spelled out in IRS publication 536, and any business owner with a good tax adviser will know about this tax-reduction strategy if it’s applicable.
Sole Proprietors and LLC’s:
Small-business owners who use a sole proprietorship can also deduct any net loss from their business (calculated on Schedule C) from their other income on their individual tax return. If the small business is a limited liability company, an S corporation or a partnership, losses that are passed through the business entity to the individual can also be deducted.
Any individual who has invested in mutual funds, stocks and bonds in a taxable account and has realized a loss in excess of their capital gains in a particular year should also be familiar with the NOL concept. Investors are allowed to deduct up to $3,000 of their excess losses (realized in taxable accounts) against income in the current year, and they can carry forward and deduct the excess losses in future years until the losses are offset by gains or other income (up to the $3,000 limit against income).
As Judge Billings Learned Hand famously argued: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”