Using Net Operating Loss Carryforwards to Offset Canceled Debt Income
When a business has a net operating loss (NOL) in one year, it can carry that loss forward to offset income in future years. This can provide valuable tax savings. However, there are special rules when it comes to using NOL carryforwards to offset canceled debt income. In this article, we’ll break down how NOL carryforwards work, the limits on their use against canceled debt income, and strategies to maximize their benefit.
What is a Net Operating Loss Carryforward?
A net operating loss occurs when a business’s deductions exceed its income in a given tax year. For example, say a business has $100,000 in deductions but only $80,000 in income. That would produce a $20,000 NOL for the year.
Instead of just losing the tax benefit of that $20,000 loss, the IRS allows businesses to carry NOLs forward to offset income in future years. This lets businesses smooth out the impact of business cycles and losses over time. Generally, an NOL can be carried forward for up to 20 years to offset future income.
Carrying losses forward provides a valuable tax deduction. It enables businesses to reduce their taxable income and tax liability in future profitable years.
Canceled Debt and Taxable Income
If a lender forgives or cancels a business’s debt, the canceled amount is treated as taxable income to the business. This is known as cancellation of debt (COD) income.
For example, say a business owes $100,000 to a lender and the lender agrees to accept $80,000 as payment in full. That cancels $20,000 of debt. The canceled $20,000 would be treated as COD income to the business, just like regular business income.
Limits on Using NOLs Against COD Income
Here’s where things get tricky. While NOL carryforwards can be used to offset COD income, there are limits:
- For COD income that is excluded from taxable income due to bankruptcy or insolvency, NOL carryforwards must be reduced dollar-for-dollar by the amount of excluded COD income. This prevents double-dipping on the tax benefit.
- For taxable COD income, NOL carryforwards can offset up to 90% of it. The remaining 10% is taxable.
Let’s look at some examples to see how this works.
Example 1: Excluded COD Income
Say a business has $100,000 in debt canceled. Due to insolvency, the business can exclude the $100,000 COD income from taxable income.
However, the business has a $50,000 NOL carryforward from the prior year. Here, the business would have to reduce its NOL carryforward to $0. It cannot use any NOL to offset the excluded COD income. This prevents double-dipping on the tax benefit.
Example 2: Taxable COD Income
Say a business has $100,000 in taxable COD income. It also has a $50,000 NOL carryforward.
Here, the business could offset 90% of the COD income by using its NOL carryforward. That’s $90,000 of the $100,000 COD income.
The remaining $10,000 of COD income is still taxable. Only 10% of taxable COD income escapes offset by prior NOLs.
Strategies for Preserving NOL Carryforwards
Given the limits on offsetting COD income, businesses may want to consider strategies to preserve existing NOL carryforwards:
- Defer additional deductions – By deferring deductions to later tax years, you can preserve NOL carryforwards for use against COD income.
- Accelerate income – Look for opportunities to accelerate income into the current year. This avoids increasing an NOL that would have to be reduced by excluded COD income.
- Consider debt restructuring alternatives – Restructuring debt to avoid COD income altogether prevents reduction in NOL carryforwards.
- Generate new losses – New NOLs created after the year of COD income are not subject to COD limits.
- Change accounting methods – Adopting accounting methods like the cash method could alter your taxable income to preserve NOLs.
- Consider S-Corp status – COD income limits don’t apply to S-Corps, so switching status could preserve NOLs.
The rules around using NOL carryforwards against COD income are complex. But some savvy tax planning can help maximize their benefit. Work closely with your tax advisor if you face canceled debt to navigate the best options for your business. With the right moves, you can continue using your NOL carryforwards to reduce taxes for years into the future.
More on Net Operating Losses and COD Income
- IRS Publication on Net Operating Losses
- Overview of COD Income Rules
- Strategies for Preserving NOL Carryforwards
- Using NOL Carryforwards to Reduce Taxes
- Overview of COD Income Rules: https://www.thetaxadviser.com/issues/2015/may/tax-clinic-06.html
- IRS on NOL Carryforward Rules: https://www.irs.gov/publications/p536#en_US_2021_publink1000202527
- Strategies for Preserving NOLs: https://answerconnect.cch.com/topic/0fc86fc87c691000a42a90b11c18c902042/effect-of-bankruptcy-and-debt-cancellation-on-nols
- IRS Pub on NOLs: https://www.irs.gov/publications/p536
- NOL Tax Benefits: https://taxfoundation.org/taxedu/glossary/net-operating-loss-carryforward/