Net operating losses occur when a company’s expenses exceed revenue for several years. Most countries have special tax rules to accommodate the ups and downs of the economic cycle. Losses can be applied to future and past income statements, reducing taxable income and overall payout. Specific rules and conditions must be met to qualify for this type of tax reduction.
Net operating losses occur when a company’s operating expenses exceed revenue for several years. Operating expenses are the costs of materials, rent, and overhead incurred in running a business. Income is all the money that flows into a business, usually from the sale of materials or services.
Business losses are incurred throughout the year, but the annual fiscal reporting process usually occurs when net operating losses are identified. In order to encourage entrepreneurship and accommodate the ups and downs of the economic cycle, most countries have special rules around the tax treatment of net operating losses. Although income gains are restricted to the year they are earned, losses can be applied to future and past income statements.
Typically, a business net operating loss can be used to reduce taxable income in more profitable years. This results in a lower income tax percentage and a lower overall payout. To support a company’s income tax relief claim, any net operating losses must be supported by the financial statements.
All tax departments have the right to audit a claim up to seven years prior to the current tax year. In an income tax audit, a trained accountant requests access to supporting documentation supporting the claim of net operating losses for the business. This can include copies of supplier invoices and invoices for customers. Bank records and reconciliations may also be reviewed to ensure that all transactions are accurately recorded.
Net operating losses have a special carry-over and return provision. Under this rule, a company can apply net operating loss to reduce taxable income for two to three years prior. This process is designed to accommodate the cyclical nature of business and the economic cycle. The net operating loss can also be extended over the next 20 years.
By providing the ability to fast forward and rewind losses in time, the government recognizes that expenses incurred from current revenue may have occurred in previous years. It’s also a relatively painless way to provide short-term funding for normally profitable businesses in a time of economic downturn. There are very specific rules and conditions that must be met to qualify for this type of tax reduction.
To find out if these types of losses can be used to reduce your income tax liability, consult an accountant or review your country’s income tax laws. Most counties have published their income tax guidelines on the Internet, making them freely available for anyone to review. The rules surrounding net operating losses are very simple and straightforward. If your situation is complicated by other factors, discuss this with your accounting services firm to determine the best course of action for your business.
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