Loss Carryback: Definition, History, and Example

Think of loss carryback as a helpful tool for businesses, almost like a time machine for taxes. When a business has a year where it loses money, it can use that loss to lower the taxes it paid in the previous year. This might even lead to getting some tax money back. However, these rules can be different depending on the country. In the United States, most businesses can’t use this method for losses after 2020. Instead, they can save those losses for the future by reducing taxes. Imagine your business didn’t do well in a certain year and ended up losing money. With loss carryback, you can use that loss to bring down the taxes you paid in a better year. It’s sort of like getting back some of the taxes you already paid. But don’t forget, there’s also something called loss carryforward. It works the opposite way. Instead of focusing on past years, it lets you keep your losses to lower taxes in the years to come.

What is Loss Carryforward?

When you have a loss, you can use it in the future to lower your taxes. This means you won’t have to pay as much in taxes in the coming years. This rule applies to losses in 2018, 2019, and 2020, and you can keep using these losses to reduce your taxes for as long as you need in the future. It’s like saving money on your taxes for years to come.

History of Loss Carrybacks

Let’s travel back in time to understand the history of loss carrybacks. This provision first came into play as part of the Revenue Act of 1918. Originally, it was designed to help companies that faced losses due to the sale of war-related items after World War I. In the beginning, companies could only carry losses back or forward for a single year. The idea was to ease the tax burden for businesses that didn’t follow the usual yearly profit pattern. This often applied to industries like farming, where success could depend on unpredictable factors like the weather.

Over the years, the rules around how long you could carry losses forward or backward have been like a rollercoaster—sometimes extended, sometimes cut short, and sometimes even taken away completely. Let’s look at some of the major changes in recent decades:

1. In 1997, the Tax Relief Act limited loss carrybacks to two years but allowed carryforwards for up to 20 years.
2. In response to events like the 9/11 attacks and the Great Recession in 2009, temporary extensions allowed carrybacks for three, four, or even five years.
3. The Tax Cuts and Jobs Act (TCJA) in 2017 removed the two-year carryback rule, except for certain farming losses and non-life insurance companies. It introduced indefinite carryforwards, but now with a limit of 80% of each following year’s net income. However, insurance companies (except life insurance) could still carry back losses for two years and forward for 20 years without the 80% limit. Farming losses also got a two-year carryback and indefinite carryforward, but they are still subject to the 80% rule.
4. In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act hit pause on the TCJA changes until January 1, 2021. It also expanded the carryback period, allowing a five-year carryback for losses incurred by non-life insurance companies and farming losses, beginning after December 31, 2017, and before January 1, 2021.

Here are the Main Points to Remember

1. Temporary Financial Help: Loss carryback offers a short-term financial lifeline to companies facing losses. It lets them use these losses to get tax refunds from previous profitable years.
2. Different Rules in Different Places: The rules for loss carryback aren’t the same everywhere. Some countries allow one-year carrybacks, while others permit two or three years. During economic crises, regulations might change temporarily.
3. Thinking About Future Profits: While loss carrybacks can provide immediate relief, it’s essential to think about what it means for the future. Using losses for carryback means they can’t be used later to reduce taxes on future profits. This might lead to higher taxes in the long run.

Loss Carryback Details

The IRS in the United States runs the show on loss carrybacks. They make the rules, and those rules can be specific. For instance, after a major tax law change in 2017, some industries like farming and insurance got special treatment with a two-year carryback for refunds. Other businesses, like non-life insurance, had their own set of rules.

This idea of carrying back losses has been around for a long time. It started back in 1918 to help businesses hit hard by World War I. Over the years, the rules have changed a lot, with different durations and restrictions. For instance, in 1997, the Tax Relief Act limited carrybacks to two years and carryforwards to twenty years.

But there are limits. One restriction, known as the capital loss carryback, means you can’t use certain losses and credits after a change in ownership.

The length of the carryback period can make a big difference to businesses. Extending it from two to five years, for example, gives them more financial flexibility. Some folks argue that this would especially help industries like homebuilding, cars, and finance.

Now, since 2018, there have been some changes. Losses in tax years after December 31, 2017, don’t have the old two-year carryback rule. Instead, a special five-year carryback was allowed under the CARES Act for tax years starting in 2018, 2019, and 2020.

Choosing a Year for Carryback

While Form T1A may not ask for details about your previous years’ returns, it’s a good idea to keep those records handy when filling out this form. Certain losses, like those from farming, fishing, low capital, and listed personal sources, can only be used to offset gains of the same type.

Temporary Suspension of Limits on Charitable Contributions

Now, here’s a bit about charitable contributions. Normally, there’s a limit on how much you can deduct for charitable cash contributions, usually around 60% of your adjusted gross income (AGI). But there’s good news for qualified donations. Individuals can deduct qualified contributions up to 100% of their AGI, while corporations can go up to 25% of their taxable income.

Carrying Amounts Back

When you’re carrying losses back, make sure it’s to a year where you reported gains in the same category. If you carry losses back to a year with no such gains, it won’t make a difference, and you might lose the opportunity to use those losses again. Form T1A is your go-to for applying a loss from the current year to any of the previous three years.

How Does Loss Carryback Work?

Let’s break it down with an example. Suppose a company had a tough year and ended up with a net operating loss of $500,000. Now, they can carry this loss back to the previous year when they made a profit of $500,000. By doing this, they wipe out their tax bill for that profitable year ($500,000 minus $500,000 equals $0). If they’ve already paid taxes on that $500,000 profit, they can even apply for a refund.

For both individuals and companies, this carryback period usually covers three years.

Why Does Loss Carryback Matter?

Now, why is this important? Well, when a company or individual faces a year of losses, they have this handy tool to offset profits from the past. It’s like using a time machine for tax planning. And guess what? They can also use this strategy for future tax planning when they predict they might have losses down the road.

Example

Suppose a company faces a net operating loss in its 5th year of business operations. Now, this loss can’t be applied to just any year; it typically goes back to either the third or fourth year of the business. If this loss carryback wipes out the entire tax liability for the third year, any remaining loss can then be allocated to the fourth year. But what if there’s still some loss left after year four? Well, that’s where it gets interesting. The extra loss can be carried forward to years 6, 7, and so on, until it’s used up entirely or reaches zero.

While loss carryback often looks back at the last two years, loss carryforward allows businesses to apply losses for up to 20 years after they occur. Different businesses have different strategies – some prefer to offset previous years’ taxes, while others save the loss for future years when they anticipate higher tax liabilities. Once a business makes the call to carry or carry forward, it’s a one-way street. There’s no turning back, so the decision needs to be made with absolute confidence.

Conclusion

In conclusion, understanding loss carryback and carryforward is essential for businesses facing financial challenges. It’s a valuable tool that can help manage taxes during tough times. However, the rules vary, so it’s wise to seek guidance from a tax professional or advisor to make the right decisions for your specific situation. Don’t hesitate to reach out for help when needed; it can make a significant difference in your financial strategy.

Frequently Asked Questions